Subprime - Definition of Subprime Borrowers and Lending

What does Subprime Mean, and Why does it Matter to Borrowers?

Mountain of Houses
After the housing boom, subprime loans are still around and come in many forms. ryccio/Digital Vision Vectors/Getty Images

Subprime loans are credited with causing the mortgage crisis in 2008, and they are still used today. While they might not trigger another global slowdown, they are still a big deal.

What is a Subprime Loan?

A subprime loan is a loan to a borrower with “less than perfect” credit. These borrowers are not what bankers consider prime borrowers (prime borrowers generally have high credit scores, low debt loads, and healthy incomes that comfortably cover any required monthly payments).

Instead, subprime borrowers and loans often have characteristics that suggest default is more likely to occur:

Credit: subprime borrowers generally have bad credit – either because they’ve had problems in the past or they’ve never had the opportunity to build credit. Unfortunately, borrowers with bad credit have few options besides subprime lenders, which can contribute to a cycle of debt. FICO credit scores below 640 are often considered subprime, but some set the bar as low as 580.

Monthly payments: subprime loans require payments that eat up a large portion of the borrower’s monthly income (as measured by the debt to income ratio). This leaves very little wiggle room if the borrower faces unexpected expenses or a loss of income. In some cases, new loans are approved even when borrowers have an existing debt burden.

Cost: subprime loans are typically more expensive because lenders want to be compensated for taking risk.

Skeptics might also say that predatory lenders know they can take advantage of desperate borrowers who don’t have any other options. Costs come in various forms including higher interest rates, processing and application fees, and prepayment penalties (which are rarely charged to borrowers with good credit).

A key theme of subprime loans is risk (for everybody involved). They are less likely to get repaid, so lenders typically charge more. Those higher costs make the loans risky for borrowers – it’s more difficult to pay off debt when you add fees and a high interest rate (see How to Calculate Loans for more details on how interest rates influence monthly payments).

Types of Subprime Loans

Subprime loans became notorious during the financial crisis as homeowners in record numbers struggled with mortgage payments. But subprime loans are available for almost anything. They are available for auto loans, credit cards, student loans, and unsecured personal loans.

Since the mortgage crisis, consumer protection laws make subprime home loans hard to find. But old (pre-crisis) loans still exist, and lenders may still find creative ways to approve loans that probably shouldn't be approved.

How to Avoid Subprime Traps

If you’re planning to borrow – or you’re already in a subprime loan – find ways to stay out of these expensive loans. In the subprime world, you have fewer options: you won’t be able to shop among as many competing lenders, and you’ll have less choice when it comes to using different types of loans for different purposes.

The key is to appear less risky to lenders. Evaluate your creditworthiness the same way they do, and you’ll know what you need to do before you even apply for a loan.

Manage your credit: if you haven’t already, check your credit reports (it’s free) and look for anything that will spook lenders. Fix any errors, and address any missed payments or defaults if possible. It may take time, but it is possible to build (or rebuild) your credit and become more attractive to lenders.

Look at your income: lenders want to be confident that you have the ability to repay. For most people, that means you’ve got a regular income that more than covers your minimum monthly payments. If a new loan (in combination with any existing loans) will eat up more than 30% or so of your income, you might need to pay off existing debts or borrow less to get the best deal.

Try new (but legitimate) lenders: a bad loan can haunt you for years, so shop around before committing to anything. Be sure to include online lenders in your search. Peer to peer lending services might be more likely to work with you than traditional banks and credit unions, and several online lenders even cater to borrowers with bad credit – while still offering decent rates. Be sure to research any "new" lenders you're considering before you pay any fees or hand over sensitive information like your Social Security Number.

Consider a co-signer: if your credit and income are not sufficient to qualify for a good loan with a traditional lender (such as a bank, credit union, or online lender), consider asking a co-signer for help. Remember that your co-signer is taking a big risk and putting their credit on the line – so don’t ask unless it’s somebody who can afford the risk, and don’t take it personally if nobody is willing to sign off on your loan.