What is a Subprime Borrower
A subprime borrower is a person considered to have relatively high credit risk for a lender. Subprime borrowers fall in a lower credit score category and have numerous adverse activities reported on their credit report such as delinquencies and account rejections. Subprime borrowers may also have a thin credit history which means they have little credit activity on a credit report or no activity at all for which to base an underwriting decision.
BREAKING DOWN Subprime Borrower
Subprime borrowers typically have credit scores below 670. This makes it hard for them to obtain credit through traditional lenders. Generally, subprime borrowers will receive less favorable loan terms in comparison to good credit quality borrowers.
Subprime lenders are willing to take on higher credit risks for the tradeoff of higher returns from higher rates of interest. While subprime lending can be a profitable business for many companies it was one of the significant factors which led to the subprime mortgage crisis in the U.S. in 2008. Many lenders specifically in the mortgage market relaxed their standards for lending in order to seek broader profitability. These mortgages resulted in higher rates of default which subsequently led to new regulations from the Dodd Frank Act, tightening the standards for lending across the credit market.
Credit Score Classifications
Lenders rely on credit reporting agencies to provide credit reports and credit scores for which lenders base their lending decisions on. Credit reporting agencies can calculate the credit scores from a variety of methodologies. FICO scoring is the most prominent method across the industry and is widely used by most credit bureaus. This credit score ranges from 300 to 850.
Experian breaks down credit scoring classifications into five tiers. Higher credit scores are associated with good credit. This encompasses the top three tiers of borrowers, all with credit scores above 670. The top three credit score classifications are known as exceptional, very good and good.
Subprime borrowers will fall in the lower two tiers which include the fair and poor categories. Fair credit category borrowers will have credit scores ranging from 580 to 669. In the poor category subprime borrowers will have a credit score of 579 or lower.
According to Experian, subprime borrowers are much more likely to have serious delinquencies. Experian reports that 27% of fair credit category borrowers and 62% of poor credit category borrowers are likely to become seriously delinquent. This reinforces the theory that subprime borrowers have higher credit risk and therefore should have less favorable lending terms
Lenders can offer a variety of products for subprime borrowers. Credit cards are some of the most common products available. Subprime credit cards provide an example of some of the less favorable market terms. Companies like Credit One Bank, First Premier Bank and First Savings Bank primarily target subprime borrowers. Interest rates on these credit cards can range up to as high as approximately 36%. These credit cards will also often include annual fees of approximately $100 a year and monthly fees ranging from $5 to $10 a month. These credit cards usually also have a lower available limit which is another lending term that lenders use to mitigate some of the subprime risks. Non-revolving credit borrowers can expect similar rates of interest. Most subprime lenders will offer non-revolving loans ranging up to approximately 36% as well.
In mortgage lending, subprime borrowers can present less risk than other types of lending because mortgages are secured by collateral. While borrowers may have subprime credit profiles and agree to high interest rates, these borrowers also agree to back the loan by a real estate property. Secured collateral can potentially broaden a creditor’s lending standards since the lender has ownership of the collateral as recourse.
Subprime Credit Alternatives
In the emerging fintech market a number of new companies have been established with the purpose of focusing on lending to subprime and thin file borrowers. Numerous credit agencies focusing on alternative credit scoring methodologies for borrowers have also been created. This has helped to increase the available offerings for subprime borrowers in the credit marketplace.
One product serving as an alternative for subprime borrowers is secured cards. The Discover it card is one of the industry’s leading secured cards. This card allows borrowers to make a small deposit as collateral against their loan balance. Discover it will generally offer credit limits of up to 50% to 100% of the collateral with collateral levels of $100 to $200 usually required.
Many alternative online lenders have also emerged with credit products targeting subprime borrowers. Elevate Credit provides one example. This company specializes in products for subprime borrowers. Their loan offerings have special features for subprime borrowers such as decreasing interest rates.
Payday lenders can also serve as a subprime credit alternative. These loans will charge borrowers interest rates that can range up to 400% annually with short term requirements for repayment. Payday lenders require employee paystubs as a primary variable for a loan approval. They also do credit underwriting that is based on credit scoring and debt-to-income ratios.