What are subprime loans?

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The label “subprime loan” carries different meanings and connotations depending on the industry, so not all subprime loans are the same. In general, however, the term “subprime loans” refers to any type of financing that pose greater risk for the lender.

Lenders who lend to sub-prime borrowers or projects typically understand what they’re getting into and will price their financing accordingly. Unfortunately, that is not always the case, as the recent mortgage crisis and the fall of Lehman Brothers dramatically exposed.

Characteristics of a subprime loan

So if the lender’s risk exposure determines what is (or isn’t) a subprime loan, what determines risk? The answer is that it depends on different factors:

  • Assets. The amount of assets a borrower currently has is one indication of the borrower’s financial abilities. Most lenders want to see that the borrowers have some assets for reserves should they experience a downturn. When the lender waives the asset requirements, they are effectively increasing the loan’s riskiness. Even worse are low- and no-down-payment loans, which basically force the lender to absorb even more of the loan’s risk.
  • Collateral. The security for the loan – or more precisely, the value of the security – helps determine the loan’s riskiness. One problem with the recent mortgage crisis is that many homes were poorly (sometimes fraudulently) appraised, so it was difficult to tell how much those homes were really worth.
  • Current income. A borrower’s or company’s revenue indicates their ability to repay the loan, but it is based on their current situation. If a person loses a job or a business starts to decline, that will increase the potential for default. Lenders have to consider those concerns in their risk calculations. Unfortunately, no income verification (NIV) and no documentation (No Doc) loans ignored this important loan risk factor.
  • Credit. Finally, the borrower’s credit history indicates their past ability to manage and repay debts. Borrowers with established AND excellent credit lower the risk of default for lenders. On the other hand, borrowers with severely damaged credit may pose higher risks for lenders.

In the consumer finance arena, a subprime loan typically refers to financing issued to individuals with damaged or less-than-prime credit. Subprime consumer loans are designed to fund transactions for those who need to build or rebuild their credit history.

Subprime loans have been in existence in many forms over the decades, but their consistent theme is that they are loans to more risky projects or borrowers. Although the term suggests that such loans are for those who do not have a prime credit rating, some borrowers with excellent credit may also be considered subprime. For example, a person may have excellent 780 credit scores, but if they have just lost their job, they would be considered subprime.

With regard to credit scores, there are no strict guidelines to determine what is and is not categorized as a subprime loan based upon a score. However, many lenders that use FICO credit scores as one of lending criteria often follow the basic grading tiers used for FICO scores.

Subprime loans can come in the same types and formats as regular non-subprime loans. For example, in addition to subprime mortgages, there are subprime automobile loans, subprime personal loans and subprime credit cards.

Because of their increased risk for lenders, subprime loans tend to charge higher interest rates compared to non-subprime loans. Some types of subprime financing also require additional collateral, as evidenced by secured credit cards. However, some unsecured loans are designed to meet some of the financing needs of subprime borrowers, including payday loans and signature loans.

For those with recent credit issues often a subprime loan is the only alternative allowing the borrower to access credit. At the same time, subprime loans do offer a secondary benefit: they give borrowers with non-existent or damage credit the opportunity to reestablish a timely payment history and repair their damaged credit.

Subprime loans are not for every borrower, but they do fulfill a certain market niche and provide a way for consumers to get needed cash, as well as to start rebuilding a solid credit history. Before any consumer takes on a subprime loan, it’s important to fully understand the benefits and costs of subprime financing programs.

Disclaimer: NetCredit is a direct personal loan provider and does not provide financial advice, nor does it vouch for any vendor or service mentioned on our NetCredit personal finance blog or online consumer loan glossary. Always research and perform due diligence on any service provider or vendor before deciding to use them, and we recommend that you speak with a financial advisor regarding all decisions that will affect your finances.

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