Sub-prime mortgage market is basically all about lending to persons with limited borrowing history or having not-so-good quality asset. Here, as borrowers cannot submit better asset for mortgage or they do not have good steady income or they do not have sufficient repayment history, accept higher interest cost for borrowed fund.
This is a high-risk high-margin business for lenders. Risky because off uncertainty regarding repayment of loan and seriously profitable since lenders do charge much above their normal prime lending rate. But like any risky business they need to manage their uncertainty.
When any borrower buys any property with fund, lent under sub-prime mortgage rate, they accept some liabilities. Firstly, he needs to service debt regularly, i.e., need to pay interest and a part of principal in regular intervals. Secondly, need to pay insurance charges, against which he enjoys insurance coverage in case of accidental loss. Thirdly, need to pay property taxes.
Default in any of the above three payments, brings in troubles. If borrower fails to pay insurance premium, he loses the coverage, which is a serious problem; if he defaults in paying property tax, tax authority can lien his property and sell it off to realize dues.
To insure against these risks, lenders have the option to build an escrow account out off lent fund. In case of default from borrowers’ side, lender can use the fund in escrow account to pay these dues off. Though, escrow account is not mandatory in sub-prime lending market till now, it has the capacity to insure against sudden defaults, which is quite expected from any sub-prime borrowers.
Financial regulator and Congress probe has revealed that absence of escrow account is major reason for recent crash in sub-prime mortgage market. Lack of proper escrow fund had aggravated the situation, which was staged following a series of payment default.
