A subprime loan is a loan offered to borrowers who don't qualify for conventional loans due to various high-risk factors such as a poor credit history, low income, and a high debt-to-income ratio. These loans generally have higher interest rates than conventional loans due to the heightened risk associated with subprime borrowers.
- What is a Subprime Loan?
- Subprime Borrower Characteristics
- Types of Subprime Loans
- How to Avoid Subprime Loan Pitfalls
What is a Subprime Loan?
Subprime loans are used as a way to offer financing to individuals with poor credit, low income, or limited credit history who don't qualify for conventional loans. Most types of loans have subprime options, which include auto loans, mortgages, and personal loans. In these cases, lenders may focus on a borrower’s income instead of their credit score to ensure that the borrower has enough money to repay the loan.
Officially, there are no credit score cutoffs for many types of loans. However, borrowers with credit scores below 650 have a hard time getting approved for conventional loans. While loan approval depends on many factors, having a good credit score is one of the most important factors because it's an indicator of whether you’re likely to pay off the loan. Subprime loans were created to help people with poor or little credit history qualify for loans and aid them in buying a house, car, or financing other things that they may not be able to fund on their own. Many borrowers may have the financial ability to pay off a loan, but need help qualifying for a loan because of their credit history.
Predatory lenders look for desperate borrowers who have exhausted other options, know little about loans, and charge these borrowers high interest and fees. In many cases, lenders tend to hinder a borrower's ability to repay the loan by charging high interest rates and by taking advantage of a borrower's situation or lack of financial understanding. Many states have laws to prevent high interest rate loans and control predatory lending, but, unfortunately, it still happens.
Pros and Cons of Subprime Loans
Subprime loans tend to have a bad reputation because of their name, high interest rates, and their association with predatory lending. However, there are some pros to getting a subprime loan when you don't qualify for a conventional loan, but are capable of repaying a loan. In the chart below, we've put together some pros and cons about subprime loans to help decide if they are right for you.
|Borrowers with poor or little credit history or a high debt-to-income ratio are able to qualify for subprime loans.||Subprime loans carry more risk to lenders which can lead to higher interest rates for borrowers.|
|These loans can help borrowers who need to pay off other debts by consolidating the debt and making payments easier.||Borrowers are more likely to default on loans and ruin their credit because of the high interest rates.|
|Subprime loans can help fix borrowers' credit score if they make timely monthly payments.||These loans generally have higher interest rates than conventional loans which can result in high monthly payments.|
|Government regulations cap how high interest rates on loans can be and enforce rules that lenders must follow.||Predatory lenders charge high interest rates or hide fees that may hurt borrowers if they are unprepared.|
|Increased opportunities for subprime borrowers to own homes, cars, and other things that they wouldn't be unable to fund on their own.||More fees including processing fees and high up-front payments that some borrowers may not be able to afford.|
Despite the positive qualities of subprime loans, you should only borrow if you are confident that you will be able to pay off the loan. Paying off the loan will benefit you by paying off other debts and fixing your credit score. Despite the benefits, there are much higher fees associated with subprime loans. Defaulting on a loan will ruin your credit.
Subprime Borrower Characteristics
Borrowers who apply for subprime loans usually share certain characteristics, which you can find below:
- A FICO credit score below 650 (according to Equifax).
- Low income.
- Little to no credit history.
- A debt-to-income ratio of 50% or more.
- Late payments on loans or credit cards.
- A foreclosure in the last 24 months.
- A bankruptcy in the last 60 months.
- Self-employed, new business owner or retiree.
Having any of these characteristics doesn't mean that you won't be able to qualify for a loan, but it may make it more difficult, and the hard inquiry from applying will lower your credit score. It's best to resolve any credit or debt issues before borrowing in order to increase your chances of approval and lower your interest rate for the loan. If you're unsure about whether you'll be able to repay the loan, it's best to wait until you've a stable income and have paid pay off any other debt you've built up.
Types of Subprime Loans
In general, there are subprime options for most loan types. All subprime loans function similarly because they're a loan for those borrowers with a high risk of defaulting due to low credit scores, poor or little credit history, a high debt-to-income ratio, or other factors.
Subprime Auto Loans
Subprime auto loans tend to have higher interest rates than conventional auto loans, and if a borrower is unable to repay the loan, the lender will repossess the car and sell it. If you miss a payment—and there is still a balance left on the loan—your lender may take you to court to sue for the remainder of the loan amount.
According to Experian, the percentage of auto loans given to borrowers with subprime credit ratings has fallen to its lowest point since 2012. Not as many subprime auto loans are approved due to critics claiming that financial institutions were offering too many loans to subprime buyers. Lenders are now looking for better credit history and more assurances that the borrower won't default on the loan.
To ensure that borrowers are able to pay their loans, lenders offer subprime auto loans with longer repayment periods. The average term for a vehicle loan in 2017 is 69 months with some terms as high as 84 months. A long term length is not ideal for borrowers because a car depreciates quickly and the longer the term, the less equity they have in the car. It may be best to consider other options such as leasing instead of a subprime loan.
Mortgage loans are generally classified as either prime or subprime, depending on the risk of a borrower defaulting on the loan. The main types of mortgage loans are adjustable rate mortgages, fixed-interest mortgages, and interest-only mortgages. A mortgage is considered subprime if it's given to someone who has poor credit—generally a credit score below 650.
In 2005, subprime mortgage lending hit an all-time high, arguably leading to the 2008 financial crisis. Lenders gave loans to people with poor credit and a high risk of default because central banks tried to stimulate the economy with lower interest rates and increasing demand for mortgages. In late 2005, home prices began to fall, which led to borrowers being unable to afford their mortgages, defaulting on their loans, and subprime lenders filing for bankruptcy.
Directly following the financial crisis, many lenders refused to give out loans to consumers with low credit scores. These days, lenders have started to offer subprime mortgage loans again, but the process is much longer requiring more documentation and lenders must verify that borrowers can pay off the loan.
Subprime Personal Loans
Most personal loans are unsecured, meaning that they're not backed by collateral and are bigger risks for lenders. Many people use personal loans to consolidate debt or fund big purchases. Subprime personal loans are for people with a high risk of default based on their credit score, which means obtaining an unsecured personal loan may be difficult without collateral, and the loan will generally have a high interest rate.
If you're unable to qualify for a subprime unsecured personal loan, lenders may offer you a secured loan that you can back with collateral, which helps lower your risk for lenders. So, if you are unable to make timely payments, the lender can seize the asset you put up for collateral and your credit will take a hit. Click here for more information on getting a personal loan with bad credit.
How to Avoid Subprime Loan Pitfalls
Subprime loans can be very risky if you're not prepared for the high interest rates, extra fees, and potentially predatory lenders. In order to avoid defaulting on a subprime loan, take steps to lower your risk and ensure that you're able to repay the loan. Here are some tips to help you avoid subprime loan traps:
- Budget your income to include the potential loan payment.
- Check your credit score and fix any errors in your credit history.
- If possible, try to improve your credit score by making on-time payments and paying down any existing debt where possible.
- Shop around for alternative lenders.
- Consider asking someone with strong credit and income to cosign on the loan.
Make sure to do enough research before paying any fees or giving out personal information. Remember that a cosigner is responsible for repaying your loan if you are unable to, so don't take it personally if you can't find anyone willing to take that risk.