Subprime Loan

What is a Subprime Loan?

A subprime loan is a loan offered to individuals at an interest rate above prime, who do not qualify for conventional loans. Such individuals have low income, limited credit history, poor quality collateral, or poor credit. The subprime option is common in many different types of loans, including auto loans and personal loans. In the case of these loans, the creditors focus on the repayment ability of the borrowers instead of their credit score.

Although there is no hard cut-off credit score for conventional loans, individuals with a credit score of less than 600 find it difficult to secure a conventional loan. Subprime loans are meant to assist people with limited credit history to qualify for loans and help them in financing their requirements. Borrowers may be financially capable to repay a loan but unable to secure a loan due to their poor credit.

Subprime Loan Types

Some of the common types of subprime loans are as follows:

1. Interest-Only Subprime Loan

The loan is structured such that borrowers pay only the interest portion during the early periods of the loan. Thus, the initial monthly payments are more affordable. However, when the payments are increased in later periods, the difference can be quite steep.

2. Fixed-Rate Subprime Loan

The rate of interest for such loans remains constant for the entire duration of the loan. However, the loan duration is usually longer than the average loan. While the usual loan is about 30 years, the duration of a fixed-rate subprime loan may extend up to 50 years. Thus, the aggregate interest paid on a fixed-rate loan tends to be higher.

3. Adjustable-Rate Subprime Loan

The rate of interest of such loans remains constant for an initial period of the loan and later changes to a variable rate. The interest rate for the later period of the loan will vary along with the market.

4. Dignity Subprime Loan

The borrowers are required to record a down payment equal to 10% of the subprime loan and accept a higher rate of interest for the starting period of the loan ­– a commonly used time frame is five years. If the borrowers make their payments on time and prove they are credit worth, the interest rate eventually reduces to the prime rate.

Characteristics of Subprime Loan Borrowers

The borrowers of subprime loans have certain characteristics in common. These are as follows:

• Low income
• A credit score below 600
• A debt-to-income ratio equal to or greater than 0.5
• Poor credit history
• Credit cards or loan payments are delayed
• Have been bankrupt once in the past 60 months
• Had a foreclosure in the past 24 months
• New business, retiree or self-employed

If a borrower has any of the above characteristics, it does not imply that he/she will not be able to secure a loan; however, it becomes more difficult. The borrower should resolve any debt or credit issues before applying for a loan to increase the probability of approval and reduce the interest rate applicable on the loan.

Benefits of a Subprime Loan

• Borrowers with low or poor credit scores can qualify for subprime loans that include many types of loans, such as mortgages and personal loans.
• A subprime loan can be used to consolidate debt, making payments easier to manage.
• If borrowers make timely payments on subprime loans, their credit scores might improve.
• Subprime loans provide opportunities to borrowers to buy homes and other goods that they would not have been able to fund otherwise.

Limitations of a Subprime Loan

• Subprime loans charge higher interest rates to compensate for the higher credit risk.
• Higher rates of interest than conventional loans can lead to higher monthly interest payments.
• Uninformed borrowers are often charged high interest rates and other fees by predatory lenders.

Related Readings

CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:

• Credit Analysis Process
• Fair Credit Billing Act (FBCA)
• Hope Credit
• Predatory Lending
• See all commercial lending resources