What does it mean and why is it important?
Subprime loans were recognized as triggering a mortgage crisis that peaked in 2008, and are still in existence today. Subprime borrowers continue to get car loans, student debt, personal loans. While newer loans may not cause a global slowdown to the same extent as a mortgage crisis, they do create problems for borrowers, lenders and others.
What is a Subprime Credit?
Subprime credit is a loan issued to a borrower with a “less than perfect” profile.
The term comes from the traditional “prime” borrower that lenders want to work with. Prime lenders have high credit scores, low debt burden, and healthy returns that comfortably cover their required monthly payments.
Borrowers, on the other hand, typically have characteristics that indicate a default probability of occurring:
Credit: Subprime borrowers usually have bad credit. They may have had debt problems in the past, or they may be new to borrowing and have not yet established a strong credit history. For lenders, credit scores below 640 tend to fall into subordinated territory, but some set at least as high as 580. Unfortunately, bad credit lenders have few options other than subprime lenders, which can contribute to the debt cycle.
Monthly Payments: Subprime loans require payments that exhaust a significant portion of the borrower’s monthly income. Loans calculate the debt-to-income ratio to determine how affordable the loans are.
Borrowers who spend most of their income on loan payments have little room to absorb unexpected expenses or loss of income. In some cases, new loan loans are approved when borrowers already have a high debt-to-income ratio.
Costs: Subprime loans are usually more expensive because lenders want compensation for taking risks.
Critics may also say that aspirational lenders know they can take advantage of desperate borrowers who don’t have many other options. Costs come in many forms, including higher interest rates, processing and application costs, and prepayment penalties (which are rarely charged to lenders with good credit).
Documentation: Primary borrowers can easily provide evidence of their ability to repay loans. They have records that show steady employment and consistent pay. They also have extra savings at banks and other financial institutions, so they can keep paying if they lose their jobs. Subprime borrowers are unable to make a strong case for continued financial stability. They may be financially stable but do not have the same documentation. Relying on the mortgage crisis, lenders have routinely accepted low-documentation applications, and some of these applications contained poor information.
Risk: A key theme of subprime loans is risk for everyone involved. Loans are less likely to be repaid, so lenders typically burden more. These higher costs make the loans risky for borrowers. It is difficult to pay off debt when you add fees and high interest rates.
For more details on how rates are directly related to monthly payments, see How to calculate loans.
Types of subprime loans
Subprime loans have become notorious in the financial crisis as homeowners in record numbers struggle with mortgage payments. But subprime loans are available for almost everyone. Currently, borrowers can find mortgage lenders in the following markets:
- Car loans, including buy-here-pay-here and title loans
- Credit Cards
- Student loans
- Unsecured personal loans
Since mortgage crises, consumer protection laws make home equity loans difficult to find. But old (pre-crisis) loans still exist, and lenders can still find creative ways to approve a loan that probably should not be approved.
How to Dodge Subprime Traps?
If you intend to lend – or if you are already in subprime credit – find a way to avoid those expensive loans.
Without perfect credit, you have fewer options: you won’t be able to buy among as many competing lenders, and you will have fewer choices when it comes to using different types of loans for different purposes. Still, you can stay away from predatory loans. The key is to appear (and actually be) less risky for lenders. Evaluate your credit the same way you will know what to do before you even apply for a loan.