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 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.
How a Subprime Loan Works
When banks lend each other money in the middle of the night to cover their reserve requirements, they charge each other the prime rate – 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 2019, the prime rate has fluctuated from 1.75% to 21.5% to 5.5% (as of January 2019).
As a result, the prime rate plays a large role in determining the interest that banks charge their borrowers. Traditionally, corporations and other financial institutions receive rates equal, or very close to the prime rate. Retail customers with good credit and strong credit histories who take out mortgages, small business loans and car loans receive rates slightly higher than, but based on, the prime rate. Applicants with low credit scores or other risk factors are offered rates by lenders that are significantly higher than the prime rate – hence the term subprime loan.
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. Still, by definition, all subprime loan rates are higher than the prime rate.
Also, borrowers might accidentally stumble into the subprime loan market by, for example, responding to an advertisement for mortgages when they actually qualify for a better rate than they are offered when they follow up on the ad. Borrowers should always check to see whether they qualify for a better rate than the one they are originally offered.
Special Considerations for Subprime Loans
On large term loans such as mortgages, the additional percentage points of interest often translate to tens of thousands of dollars' worth of extra interest payments over the life of the loan. This can make paying off subprime loans difficult for 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 and the ensuing Great Recession.
[Important: The higher interest rates on subprime loans can translate into tens of thousands of dollars in additional interest payments over the life of a mortgage.]
While any financial institution could offer a loan with subprime rates, there are subprime lenders that focus on loans with high rates. Arguably, these lenders give borrowers who have trouble getting 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.
However, getting a subprime loan may still be a sensible 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.