Tips Clear News Portal Your Ultimate Guide to Clear Tips on Life, Tech, Health, and More What Is Subprime?
Subprime is a below-average credit classification of borrowers with a tarnished or limited credit history, and which are subject to higher than average interest rates. Lenders will use a credit scoring system to determine which loans a borrower may qualify for. Subprime loans carry more credit risk, and as such, will carry higher interest rates as well.
Key Takeaways
- Subprime refers to borrowers or loans, usually offered at rates well above the prime rate, that have poor credit ratings.
- Subprime lending is higher risk, given the lower credit rating of borrowers, and has in the past contributed to financial crises.
- Subprime makes up about one-quarter of the domestic housing market, but subprime products may also include non-mortgage loans and credit.
Understanding Subprime
Occasionally, some borrowers might be classified as subprime despite having a good credit history. The reason for this is because the borrowers have elected to not provide verification of income or assets in the loan application process.
The loans in this classification are called stated income and stated asset (SISA) loans or even no income, no asset (NINA) loans. Approximately 25% of mortgage originations are classified as subprime. The term subprime gets its name from the prime rate, which is the rate at which people and businesses with an excellent credit history are allowed to borrow money.
In mortgage lending, subprime borrowers can relatively present less risk than in other types of unsecured subprime lending products because the mortgage itself is secured by the home as collateral. Still, subprime borrowers may have a more difficult time obtaining a mortgage and can expect to pay a higher interest rate than the average borrower if they do.
Subprime Mortgages and the Global Financial Crisis
Many of the subprime mortgages made in the years before the global financial crisis were made with an adjustable interest rate that allowed borrowers to start the first several years of their mortgage with an extremely low payment. After the first three or five years, the interest rate adjusted upward and made the monthly mortgage payments extremely expensive for the borrowers. Many borrowers could not afford to pay them after this adjustment took place.
Before the global financial crisis, subprime loans such as mortgages were packaged together into large pools of loans and sold to investors. It was assumed that there was safety in numbers and because so many thousands of loans were pooled together, it was thought that even if some of them defaulted, the mortgage pools would remain sound investments because of the false assumption that the majority of the borrowers would still pay their mortgage payments.
The thousands of loans made to people who could no longer afford to make the payments after their interest rates adjusted upward ended up defaulting, the pooled mortgage investments went under, and all of this helped to fuel the global financial crisis.
Other Subprime Products
In today’s emerging fintech market, a number of new companies, including various online lenders, now focus on subprime and thin-file borrowers. Credit agencies have also developed new credit scoring methodologies for such borrowers. This has helped to increase the available offerings for subprime borrowers.
One widely available product that provides an alternative for subprime borrowers is the secured credit card. The borrower puts money into a special bank account and is then allowed to spend up to a certain percentage of that amount, using the secured card. After a period of time, the borrower may be eligible to upgrade to a credit card with a higher credit limit.
Some companies also offer conventional, unsecured credit cards tailored to subprime borrowers. They include Credit One Bank, First Premier Bank, and First Savings Bank. The interest rates on these credit cards can top 30%, and they often carry annual fees of $100 or so and monthly fees ranging from $5 to $10 a month. These cards usually also have a lower credit limit than other cards, which is another way lenders mitigate some of the subprime risks.
In addition to credit cards, many subprime lenders also offer non-revolving loans, such as car loans, with interest rates in the range of 36%.
Payday lenders are another, more controversial, subprime credit alternative. These lenders provide short-term loans at annual percentage rates (APRs) that can exceed 400% in some states.