Subprime is a classification of loans offered at rates greater than the prime rate to individuals who are unable qualify for prime rate loans. This usually occurs when borrowers have poor credit and, as a result, the lender views them as higher risk.

Loan qualification is based on a number of factors including income, assets and credit rating. In most cases, subprime borrowers have questions marks surrounding them in one or more of these areas, such as a poor credit rating or an inability to prove income. For example, someone with a credit rating below 620 or with no assets will likely not qualify for a traditional mortgage and will need to resort to a subprime loan to gain the necessary financing. Read on to learn more about this type of lending and how it got its bad reputation.

Subprime Vs. Prime
In addition to having higher interest rates than prime-rate loans, subprime loans often come with higher fees. And, unlike prime-rate loans, which are quite similar from lender to lender, subprime loans vary greatly. A process known as risk-based pricing is used to calculate mortgage rates and terms - the worse your credit, the more expensive the loan.

Subprime loans are usually used to finance mortgages. They often include prepayment penalties that do not allow borrowers to pay off the loan early, making it difficult and expensive to refinance or retire the loan prior to the end of its term. Some of these loans also come with balloon maturities, which require a large final payment. Still others come with artificially low introductory rates that ratchet upward substantially, increasing the monthly payment by as much as 50%.

Borrowers often do not realize that a loan is subprime because lenders rarely use that terminology. From a marketing perspective, "subprime" is not an attractive term. (To learn more, read Subprime Is Often Subpar.)

History
The Community Reinvestment Act of 1977 and later liberalization of regulations gave lenders strong incentive to loan money to low-income borrowers. The Deregulation and Monetary Control Act of 1980 enabled lenders to charge higher interest rates to borrowers with low credit scores. Then, the Alternative Mortgage Transaction Parity Act, passed in 1982, enabled the use of variable-rate loans and balloon payments. Finally, the Tax Reform Act of 1986 eliminated the interest deduction for consumer loans, but kept the mortgage interest deduction. These acts set the onslaught of subprime lending in motion. (To learn more, read The Mortgage Interest Tax Deduction.)

Over time, businesses adapted to this changing environment, and subprime lending expansion began in earnest. While subprime loans are available for a variety of purchases, mortgages are the big-ticket items for most consumers, so an increase in subprime lending naturally gravitated toward the mortgage market. According to statistics released by the Federal Reserve Board in 2004, from 1994 to 2003, subprime lending increased at a rate of 25% per year, making it the fastest growing segment of the U.S. mortgage industry. Furthermore, the Federal Reserve Board cites the growth as a "nearly ten-fold increase in just nine years."