Learn What Subprime Means: Loans and Borrowers
What Does Subprime Mean, and Why Does it Matter?
Subprime loans are credited with causing the mortgage crisis that peaked in 2008, and they continue to exist today. Subprime borrowers still get loans for automobiles, student debt, personal loans. While newer loans might not trigger a global slowdown on the same scale as the mortgage crisis, they create problems for borrowers, lenders, and others.
What is a Subprime Loan?
A subprime loan is a loan issued to a borrower with a “less than perfect” profile.
The term comes from the traditional “prime” borrower that lenders are eager to work with. Prime borrowers have high credit scores, low debt loads, and healthy incomes that comfortably cover their required monthly loan payments.
Subprime borrowers, on the other hand, typically have characteristics that suggest default is more likely to occur:
Credit: Subprime borrowers usually have bad credit. They may have had problems with debt in the past, or they may be new to borrowing and have not yet established a strong credit history. For lenders, FICO credit scores below 640 tend to fall into subprime territory, but some set the bar as low as 580. Unfortunately, borrowers with bad credit have few options besides subprime lenders, which can contribute to a cycle of debt.
Monthly payments: Subprime loans require payments that eat up a significant portion of the borrower’s monthly income. Lenders calculate a debt to income ratio to determine how affordable loans are.
Borrowers who spend most of their income on loan payments have little wiggle room to absorb unexpected expenses or a loss of income. In some cases, new subprime loans get approved when borrowers already have high debt to income ratios.
Cost: Subprime loans are typically more expensive because lenders want compensation for taking risk.
Critics might also say that predatory lenders know they can take advantage of desperate borrowers who don’t have many 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).
Documentation: Prime borrowers can easily provide proof of their ability to repay loans. They have records showing steady employment and consistent pay. They also have additional savings in banks and other financial institutions so that they can keep up with payments if they lose their jobs. Subprime borrowers are not able to make a strong case for continuing financial stability. They might be financially stable, but they don’t have the same documentation. Leading up to the mortgage crisis, lenders routinely accepted applications for low-documentation loans, and some of those applications contained bad information.
Risk: The key theme of subprime loans is risk for everybody involved. The loans are less likely to get repaid, so lenders typically charge more. Those higher costs make the loans risky for borrowers as well. It’s hard to pay off debt when you add fees and a high interest rate.
For more details on how rates are directly related to monthly payments, see How to Calculate Loans.
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. Currently, borrowers may find subprime lenders in the following markets:
- Auto loans, including buy-here-pay-here and title loans
- Credit cards
- Student loans
- 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 Dodge Subprime Traps
If you’re planning to borrow—or if you’re already in a subprime loan—figure out a way to avoid those expensive loans.
Without perfect credit, 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. Still, you can stay away from predatory loans.
The key is to appear (and actually be) 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 for U.S. consumers to view reports) 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 need 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 percent or so of your income, you might need to pay off current debts or borrow less to get the best deal.
Try new (but legitimate) lenders: A lousy 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.
Minimize borrowing: If loan sharks are the only lenders nibbling at your applications, reconsider whether or not your loan makes sense. It may be better to rent housing for a few years instead of buying, although there are certainly pros and cons with waiting. Likewise, it may be best to purchase an inexpensive used vehicle (as long as it’s safe) instead of a brand-new car.
Consider a cosigner: If your credit and income are not sufficient to qualify for a good loan with a mainstream lender (such as a bank, credit union, or online lender), consider asking a cosigner for help. A cosigner applies for the loan with you and is 100 percent responsible for paying off the loan if you fail to do so. As a result, your cosigner is taking a big risk and putting their credit on the line. Ask for help from somebody who has strong credit and income and who can afford the risk—and don’t take it personally if nobody is willing to take that risk.