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 many 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."
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.
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. This can prove to be risky business if people become unable to repay their loans and mortgage rate loss rates climb. In 2007, New Century Financial Corp, which was then a popular subprime mortgage lender filed for bankruptcy
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.)
When used responsibly by lenders, subprime loans can provide purchasing power to individuals who might not otherwise have access to funds. However, as the 2007-2010 subprime mortgage crisis illustrates subprime loans can be highly risky. (For an in-depth look on the subprime crisis, read: The Fuel That Fed The Subprime Meltdown).