What Is Subprime Credit?

Subprime credit refers to loans, usually offered at rates well above the prime rate, made to borrowers with poor credit ratings.

Key Takeaways

  • Subprime credit refers to loans, usually offered at rates well above the prime rate, made to borrowers with poor credit ratings.
  • Subprime credit is, often, the only type of loan available to borrowers with low credit ratings, high debt levels, a record of delinquency, defaults or bankruptcy, and without property or assets that can be used as collateral.
  • Consumer advocates say subprime credit is a social good and provides finance to low-income households even though it increases the risk of credit booms and busts.

Understanding Subprime Credit

Subprime credit is, often, the only type of loan available to borrowers with low credit ratings, high debt levels, a record of delinquency, defaults or bankruptcy, and without property or assets that can be used as collateral. Lenders use a credit scoring system, like FICO scores, to classify subprime borrowers based on the probability of repayment. Different creditors use different rules for what constitutes a subprime loan, but FICO scores below 619 have typically been classified as subprime in the past.

Subprime credit is financed by repackaging subprime credit card debt, auto loans, business loans and mortgage into pools and selling them investors as asset-backed securities, like collateralized debt obligations (CDO) and mortgage-backed securities (MBS).

During the housing boom in the early 2000s, lending standards on subprime mortgages were relaxed, with NINJA loans being made to borrowers with no income, no job or assets. When the bubble burst in 2007, the quantity of subprime credit in the financial markets contributed to the subprime meltdown and the subprime crisis, which triggered the Great Recession.

Consumer advocates say subprime credit is a social good and provides finance to low-income households. Yet it increases the risk of credit booms and busts. In the U.S., banks tightened lending standards after the financial crisis.

However, auto finance companies have used low interest rates to fuel a boom in subprime auto loans which has helped the economy to recover. However, auto loan delinquencies hit crisis levels in 2017, even as subprime auto-lending continued to boom, leading to speculation that this another credit bubble in the making which will ultimately burst.