What Is a Subprime Lender?
A subprime lender specializes in lending to borrowers with weak or limited credit history. A smaller number of large lenders focus on subprime lending compared to lenders that focus on prime rate loans.
- Subprime lenders offer loans to individuals with weak or limited credit histories.
- Subprime lenders generally charge higher interest rates, greater closing costs, and larger down payments.
- Subprime lenders use risk-based pricing systems to calculate loan terms and interest rates.
How Subprime Lenders Work
Subprime lenders offer loans to individuals who do not qualify for prime rate loans. By definition, all subprime loans have rates higher than the prime rate offered on conventional loans. However, subprime borrowers often have been turned down by traditional lenders because of their low credit ratings or other factors that suggest they have a reasonable chance of defaulting on the debt repayment.
Subprime lenders use risk-based pricing systems to calculate the terms of the loans and interest rates they offer to borrowers with varying credit histories. Risk-based pricing looks at factors such as a consumer’s credit score, adverse credit history, employment status, and income. It does not consider factors such as race, color, national origin, religion, gender, marital status, or age, all of which are prohibited by the Equal Credit Opportunity Act.
Subprime borrowers typically have low credit ratings, such as a FICO score of 650 or below. To determine credit scores, FICO weighs each category differently for each. However, in general, payment history is 35% of the score, accounts owed is 30%, length of credit history is 15%, new credit is 10%, and credit mix is 10%.
Subprime lenders offer auto loans as well as mortgages and other types of loans. For mortgages, for example, subprime lenders may structure the financing as adjustable-rate, fixed-rate, interest-only, or "dignity" subprime loans, so subprime borrowers may save money by shopping around.
Subprime loans are more likely to go into default than prime loans.
Subprime Loans vs. Prime Loans
Subprime loans have a higher risk of default than prime loans, and the subprime loan market has more variation in terms and rates than the prime market. Subprime loans may have higher interest rates, higher closing costs, and require a more substantial down payment. With a term loan, such as a mortgage, each additional percentage point of interest often translates into tens of thousands of dollars’ worth of added payments over the life of the loan.
The securities issued when subprime loans are repackaged and sold on the market tend to carry additional credit risk but less interest-rate risk than do prime loan–packaged securities. This additional credit risk comes from the subprime borrowers having shorter time-horizon loans and fewer opportunities to refinance their mortgages when interest rates fall.
Special Considerations Around Subprime Lenders
Any financial institution may offer a loan with subprime rates, but there are subprime lenders that focus on them. These lenders allow borrowers who have trouble accessing lower-interest-rate loans the ability to access capital and grow their businesses or buy homes.
However, there are indications that some subprime lenders use predatory lending practices to entice borrowers. Predatory lending includes any improper actions carried out by a lender to attract, induce, or assist a borrower in taking a loan that carries high fees, a high-interest rate, strips the borrower of equity, or places the borrower in a lower credit-rated loan to the benefit of the lender. Also, these practices increase the borrower’s likelihood of default.
Rampant subprime lending led to the 2007 subprime meltdown and contributed to the Great Recession, one of the most severe economic downturns in decades. To avoid the possibility of another event of this nature, the Federal Deposit Insurance Corporation (FDIC) acts as industry watchdog for instances of predatory lending. It offers consumer information on its website to help consumers spot and report improper lending behaviors.
Borrowers should do research to make sure that they are not being charged more interest than they should be for their credit history and score. For example, they need to be careful when responding to an advertisement, that they are not stumbling into a loan category that's worse than they merit. It's always important to research other loans before accepting an offer.