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.)