What Are Subprime Rates?
Subprime rates are higher than average interest rates charged to subprime borrowers, such as on loans to people with poor credit scores from one or more credit bureau. Subprime rates will be higher than prime rates for the same type of loan, although there is no exact amount or spread that constitutes subprime.
- Subprime rates are higher than average interest rates charged on loans to riskier borrowers.
- These rates are offered, for instance, to borrowers with a poor or thin credit history or low credit score.
- The higher interest rate is intended to compensate for the greater degree of risk and higher likelihood of delinquency or default on these loans.
Understanding Subprime Rates
Subprime rates can be significantly higher than rates on loans to more creditworthy "prime" borrowers.
Factors that affect subprime rates include the size of the loan, the income of the individual, the number of delinquent accounts on the borrower's credit report and the amount of the down payment for a given loan. A subprime borrower is a person considered to be a relatively high credit risk for a lender. Subprime borrowers have lower credit scores and are likely to have multiple negative factors in their credit reports, such as delinquencies and account rejections. Subprime borrowers may also have a "thin" credit history, meaning they have little or no activity in their credit reports on which lenders can base their decisions.
Subprime lenders use what is called "risk-based pricing" to determine how much interest to charge on a given loan or class of borrower. This pricing method may change as economic conditions change in the broad financial markets.
Approximately 25% of mortgage originations are classified as subprime. The term subprime gets its name from the prime rate, which is the rate at which people and businesses with an excellent credit history are allowed to borrow money. Subprime rates might be applied to home mortgages as well as to auto loans and leases, particularly for cars offered with no money down or for buyers with limited or poor credit histories.
Why Subprime Rates Draw Scrutiny from Regulators
The escalation of subprime rates has been cited as one of the contributing elements to the housing and mortgage crisis. The higher rates were noted as more homes lapsed into foreclosure as the borrowers could not keep up with the payments.
A concern regarding subprime rates is that borrowers who could not otherwise afford real estate, cars, credit card, or other financing cab take on more debt than they can realistically afford to pay off. The introductory interest rate might be lower, making it attractive to more borrowers. While they may be offered this financing with what appears to be sound deal, the terms and interest obligations can lead to the borrower building up increasing amounts of debt without making substantial gains in reducing the outstanding balance they owe. Once the introductory period has passed, the borrower will face the subprime rates for the duration of the loan.
The mounting interest under subprime rates could lead to the borrower facing more debt than the original asset is worth on the market. This can be a particular issue with mortgages and the resale of homes. If the subprime rate escalates debt to the point where the borrower cannot afford to continue to make payments. Furthermore, putting the house up for sale offers no remedy if the debt outweighs any gains a buyer’s bid might offer.
The federal government has previously negotiated with the credit industry to temporarily freeze subprime interest rates to stem the tide of foreclosures in housing.