What is a 'Subprime Loan'

A subprime loan is a type of loan offered at a rate above prime to individuals who do not qualify for prime rate loans. Quite often, subprime borrowers are turned away from traditional lenders because of their low credit ratings or other factors that suggest they have a reasonable chance of defaulting on the debt repayment.

BREAKING DOWN 'Subprime Loan'

Subprime loans tend to have a higher interest rate than the prime rate offered on conventional loans. On large term loans such as mortgages, the additional percentage points of interest often translate to tens of thousands of dollars' worth of additional interest payments over the life of the loan.

This can make paying off subprime loans difficult for most low-income subprime loan borrowers as it did in the late 2000s. In 2007, high rates of subprime mortgages began to default, and ultimately this subprime meltdown was a significant contributor to the financial crisis of the late 2000s. (For more insight on the subprime crisis, see: Who is to Blame for the Subprime Crisis?)

However, getting a subprime loan can still be an option if the loan is meant to pay off debts with higher interest rates, such as credit cards or if the borrower has no other means of obtaining credit.

What Interest Rates Do Subprime Loans Have?

The specific amount of interest charged on a subprime loan is not set in stone. Different lenders may not evaluate a borrower's risk in the same manner. This means a subprime loan borrower has an opportunity to save some additional money by shopping around. However, by definition, all subprime loans have rates higher than the prime rate.

How Does the Prime Rate Affect Subprime Loans?

The prime rate is the interest rate set by the Federal Reserve. Representatives of the Fed meet several times per year to set the prime rate, and from 1947 to 2018, the prime rate has fluctuated from 1.75% to 21.5% to 4.5% (as of January 2018).

When banks lend each other money in the middle of the night to cover their reserve requirements, they charge each other the prime rate. As a result, this rate plays a large role in determining what banks charge their borrowers. Traditionally, corporations and other financial institutions receive rates equal or very close to the prime rate. Retail customers taking out mortgages, small business loans, and car loans receive rates slightly higher than but based on, the prime rate. Lenders offer applicants with low credit scores or other risk factors loans with rates significantly higher than the prime rate, called subprime loans.

Who Offers Subprime Loans?

Any financial institution could offer a loan with subprime rates, but there are subprime lenders that focus on loans with high rates. Arguably, these lenders give borrowers who have trouble accessing low interest rates the ability to access capital to invest, grow their businesses or buy homes. However, subprime lenders have been accused of predatory lending, which is the practice of giving borrowers loans with unreasonable rates and locking them into debt or increasing their likelihood of defaulting. (For more on the dangers of subprime loans and to gain insights on the subprime mortgage crisis, see: Subprime Meltdown.)

RELATED TERMS
  1. Subprime Lender

    A subprime lender specializes in lending to borrowers with a ...
  2. Subprime Auto Loan

    A subprime auto loan is approved for people with substandard ...
  3. Subprime

    Subprime is a classification of borrowers with a tarnished or ...
  4. Subprime Mortgage

    A subprime mortgage is a type of mortgage that is normally made ...
  5. Subprime Meltdown

    The subprime meltdown includes the economic and market fallout ...
  6. B/C Loan

    A B/C loan is a loan to a subprime or thin file borrower.
Related Articles
  1. Investing

    Subprime Lending: Helping Hand or Underhanded?

    These loans can spell disaster for borrowers, but that doesn't mean they should be condemned.
  2. Personal Finance

    Subprime Auto Delinquency Rates on the Rise (NICK, CPSS)

    Fitch Ratings reports that delinquency rates for auto loans are nearing 2008 crisis level. What's driving the surge of default? Subprime loans, of course.
  3. Insights

    The 2007-08 Financial Crisis In Review

    If you don't know how the recession began, read on to learn more.
  4. Insights

    The Fuel That Fed The Subprime Meltdown

    Take a look at the factors that caused this market to flare up and burn out.
  5. Insights

    Auto Delinquency Rates Near 2008 Highs

    Auto delinquency rates edge close to the peak reached during the height of the financial crisis, fueling speculation that subprime lending is rife again.
  6. Investing

    Back to the Future: AAA Bonds Backed by Risky Debt

    Bonds backed by risky mortgage loans received AAA ratings by two ratings agencies less than ten years after the subprime crisis
  7. Investing

    The Great Recession's Impact on the Housing Market

    Home buyers should heed the warnings of why the Great Recession occurred in the first place.
  8. Personal Finance

    Personal Loans vs. Car Loans

    How to tell whether a personal loan or a car loan is better for you.
  9. Insights

    The Fall of the Market in the Fall of 2008

    How did America's strong economy tumble so quickly? Find out here.
  10. Personal Finance

    Different needs, different loans

    When it comes to loans, there are many different types according to your needs. Find out what options are available when it comes to borrowing money.
RELATED FAQS
  1. What is a subprime mortgage?

    A subprime mortgage is a type of loan granted to those who would not be able to qualify for conventional mortgages, usually ... Read Answer >>
  2. What is a liquidity squeeze?

    A liquidity squeeze occurs when a financial event sparks concerns among financial institutions (such as banks) regarding ... Read Answer >>
  3. What is happening during a risk repricing?

    During a strong bull market, the market's overall sense of optimism can often lead to poor estimates about the level of risk ... Read Answer >>
  4. Fixed and variable rate loans: Which is better?

    Interest on variable interest rate loans move with market rates; interest on fixed rate loans will remain the same for that ... Read Answer >>
Hot Definitions
  1. Gross Margin

    A company's total sales revenue minus its cost of goods sold, divided by the total sales revenue, expressed as a percentage. ...
  2. Inflation

    Inflation is the rate at which prices for goods and services is rising and the worth of currency is dropping.
  3. Discount Rate

    Discount rate is the interest rate charged to commercial banks and other depository institutions for loans received from ...
  4. Economies of Scale

    Economies of scale refer to reduced costs per unit that arise from increased total output of a product. For example, a larger ...
  5. Quick Ratio

    The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets.
  6. Leverage

    Leverage results from using borrowed capital as a source of funding when investing to expand the firm's asset base and generate ...
Trading Center