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 than do lenders who focus on prime lending. Also, the subprime loan market has more layering in the variation in terms and rates than the prime market.
BREAKING DOWN Subprime Lender
Subprime lenders offer subprime 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 which suggest they have a reasonable chance of defaulting on the debt repayment.
Subprime loans have a higher risk of default than loans to prime borrowers. As a result, they may have higher interest rates, higher closing costs, or 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.
Predatory Subprime Lenders
Any financial institution may offer a loan with subprime rates, but there are subprime lenders who focus on just these loans with higher interest rates. 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 and assist a borrower in taking a loan which 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 one of the most severe recessions 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. They offer consumer information on their website to help consumers spot and report improper lending behaviors.
How Subprime Lenders Evaluate Borrowers
Subprime lenders use risk-based pricing systems to calculate the terms of loans, and the interest rate, 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 which is not allowed based on the Equal Credit Opportunity Act.
Subprime borrowers typically have low credit ratings, such as a FICO score of 660 or below. To determine credit scores, the Fair Isaac Corporation 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. 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.