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.)

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."

The Good
Subprime loans have increased the opportunities for homeownership, adding nine million households to the ranks of homeowners in less than a decade and catapulting the United States into the top tier of developed countries on homeownership rates, on par with the United Kingdom and slightly behind Spain, Finland, Ireland and Australia, according to the Federal Reserve. More than half of those added to the ranks of new homeowners are minorities. Because home equity is the primary savings vehicle for a significant percentage of the population, home ownership is a good way to build wealth.

The Bad
Subprime loans are expensive. They have higher interest rates and are often accompanied by prepayment and other penalties. Adjustable-rate loans are of particular concern, as the payments can jump dramatically when interest rates rise. (To learn more about adjustable rates loans, see Mortgages: Fixed-Rate Versus Adjustable-Rate and American Dream Or Mortgage Nightmare?) All too often, subprime loans are made to people who have no other way to access funds and little understanding of the mechanics of the loan.

On the lending side, the rush to bring in new business can lead to sloppy business practices, such as giving out loans without requiring borrowers to provide documented proof of income and without regard to what will happen if interest rates rise.

The Ugly
Because subprime borrowers generally aren't favorable candidates for more traditional loans, subprime loans tend to have significantly higher default rates than prime-rate loans. When interest rates rise rapidly and housing values stagnate or fall, the ripple effects are felt across the entire industry.

The borrowers' inability to meet their payments or to refinance (due to prepayment penalties) causes borrowers to default. As foreclosure rates rise, lenders fail. Ultimately, the investors that purchased mortgage-backed securities based on subprime loans also get hurt when the underlying loans default. (To learn more about how this works, read Behind The Scenes Of Your Mortgage.)

Buyer Beware
When used responsibly by lenders, subprime loans can provide purchasing power to individuals who might not otherwise have access to funds. While negative attention is often focused on the mortgage industry, particularly on subprime lenders, the borrowers themselves share some responsibility for the problems subprimes have caused in the market. In other words, borrowers should never sign papers for a loan they do not understand or have the ability to repay. Despite the fact that a significant segment of subprime borrowers default on their loans, the loans themselves are neither good nor evil. They are simply an economic tool.

For a one-stop shop on subprime mortgages and the subprime meltdown, check out the subprime Mortgages Feature.

Related Articles
  1. Credit & Loans

    Have Bad Credit? 6 Ways to a Personal Loan Anyway

    It'll cost you more, but borrowing is definitely doable. Here's how to proceed.
  2. Retirement

    5 Reasons Retirees Are Upsizing Instead of Downsizing Their Homes

    Many retirees opt to downsize to save money, but there are many who are doing the opposite and upsizing.
  3. Retirement

    What Was The Glass-Steagall Act?

    Established in 1933 and repealed in 1999, the Glass-Steagall Act had good intentions but mixed results.
  4. Home & Auto

    Is Making Biweekly Mortgage Payments A Good Idea?

    Some people believe making mortgage payments every two weeks, as opposed to once a month, can chop years off of a home loan. But is it really a good idea?
  5. Investing

    Is US Inflation Too Low?

    One reason the Fed has delayed its first rate hike: U.S. inflation has been persistently running below the stated 2 % level the central bank seeks to target.
  6. Forex

    How CPI Affects the Dollar Against Other Currencies

    The Consumer Price Index is a broad measure of inflation, and inflation can have a dramatic impact on a currency's value against rival currencies.
  7. Credit & Loans

    Try This Home-Equity-Line-of-Credit Hybrid

    This product is essentially a home-equity loan and home equity line of credit (HELOC) hybrid, and it has its own quirks, benefits and drawbacks.
  8. Home & Auto

    Why You May Not Be Ready To Buy a Home

    Many dream of home ownership, but the timing should be right. There are a host of reasons why you may want to put off homeownership for awhile.
  9. Home & Auto

    The Smartest Way to Tap Your Home Equity

    Using your home as a source of funds can be a smart choice in some situations. Just be sure to carefully run the numbers.
  10. Economics

    3 Key Words in the Fed's Interest Rate Statement

    When you read the Federal Reserve Statement, read between the lines. There are three words in the last statement that especially stood out.
  1. Do lower interest rates increase investment spending?

    Lower Interest rates encourage additional investment spending, which gives the economy a boost in times of slow economic ... Read Full Answer >>
  2. Who decides when to print money in the US?

    The U.S. Treasury decides to print money in the United States as it owns and operates printing presses. However, the Federal ... Read Full Answer >>
  3. Why do some people claim the Federal Reserve is unconstitutional?

    The U.S. Constitution does not mention the need for a central bank, nor does it explicitly grant the government the power ... Read Full Answer >>
  4. How do I calculate how much home equity I have?

    Even though it is normally assumed most people know their home equity, many are still confused about the topic. It is an ... Read Full Answer >>
  5. What are the goals of a "dove" Federal Reserve head?

    The goals of a dovish Federal Reserve head are to maintain low interest rates, stimulate the overall economy, decrease the ... Read Full Answer >>
  6. What is the opposite of a "dove"?

    A dove is an economic policy adviser who favors maintaining low interest rates in hopes of stimulating the economy, while ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  2. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  3. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  4. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
  5. Black Monday

    October 19, 1987, when the Dow Jones Industrial Average (DJIA) lost almost 22% in a single day. That event marked the beginning ...
  6. Monetary Policy

    Monetary policy is the actions of a central bank, currency board or other regulatory committee that determine the size and ...
Trading Center