What Is a Subprime Loan?
Let me explain what a subprime loan is: it's a loan given at an interest rate above the prime rate to people who can't get prime-rate loans. You see, subprime borrowers often get rejected by regular lenders due to low credit scores or other signs that they might default on repayments.
Key Takeaways
- Subprime loans have interest rates higher than the prime rate.
- Subprime borrowers usually have low credit ratings or are seen as likely to default.
- Subprime rates differ between lenders, so you should compare options before picking one.
How a Subprime Loan Works
When banks lend money to each other for reserve needs, they use the prime rate, which is based on the federal funds rate set by the Federal Reserve's Federal Open Market Committee. As the Fed notes, they don't directly set the prime rate, but banks base it on the fed funds rate for short-term loans.
The prime rate has varied a lot, from 2% in the 1940s to 21.5% in the 1980s. At the December 18, 2024 FOMC meeting, the Fed cut the fed funds rate by 0.25% to fight inflation. Since the 1990s, the prime rate is typically 300 basis points above the fed funds rate, making it 7.5% right now in January 2025.
This prime rate heavily influences what banks charge borrowers. Big companies and institutions get rates close to prime. Everyday customers with solid credit get slightly higher rates for things like mortgages or car loans. But if you have a low credit score or other risks, lenders offer rates much higher than prime—that's your subprime loan.
The exact interest on a subprime loan isn't fixed; lenders assess risk differently. So, as a borrower, you can potentially save by shopping around. By definition, though, all subprime rates exceed the prime rate.
Sometimes borrowers end up in subprime territory by mistake, like responding to a mortgage ad only to get offered a worse rate than they qualify for. You should always verify if you can get a better deal than what's initially proposed.
Important Note on Costs
Those higher rates on subprime loans can add up to tens of thousands in extra interest over the loan's life.
Special Considerations for Subprime Loans
For long-term loans like mortgages, the extra interest points can mean massive additional payments, making it tough for low-income folks to keep up—as happened in the late 2000s. In 2007, defaults on subprime mortgages spiked, fueling the financial crisis and Great Recession. Many banks then exited subprime lending, but it's picking up again lately.
Any bank could issue subprime-rate loans, but some specialize in them, offering high-rate options as second chances. These can help you access funds to invest, expand a business, or buy a home if low rates are out of reach.
Subprime lending often gets labeled as predatory, with unfair rates that trap people in debt or push defaults. Still, it might make sense if you're using it to pay off even higher-interest debts like credit cards, or if it's your only credit option.
What Is the Problem With Subprime Loans?
If you've been denied loans for bad credit, you might grab a subprime offer despite its high rates or fees. These loans often have rates 8%-10% above prime mortgages, plus steeper upfront costs.
Who Benefits From Subprime Loans?
People who couldn't qualify otherwise get a shot at homeownership without waiting. If you make payments on time, your credit score improves, and with enough progress, you might refinance to a prime loan.
Do Subprime Loans Still Exist?
They're not as widespread as in the early 2000s, but you can still find them. Now, they come with tighter rules and restrictions.
The Bottom Line
Subprime loans provide a real path to mortgages for those who wouldn't qualify otherwise. Yes, the rates and fees are higher, but consistent payments can boost your credit score over time.
Other articles for you
Operation Twist is a Federal Reserve strategy to stimulate the economy by lowering long-term interest rates through buying long-term bonds and selling short-term ones.
HIBOR is Hong Kong's benchmark interbank lending rate, used for various financial products but facing criticism and potential replacement.
EMEA is a geographical acronym used by global corporations to group Europe, the Middle East, and Africa for business purposes.
This text provides an overview of fundamental analysis as a key investing tool, including principles, metrics, FAQs, and related terms.
Berkshire Hathaway is a massive holding company led by Warren Buffett, known for its diverse businesses, investments, and exceptional stock performance.
The text explains the bull put spread options strategy for moderately bullish investors, including its construction, profits, losses, pros, cons, and an example.
A fidelity bond is a type of business insurance that protects employers from financial losses due to employee fraud or dishonesty.
The accounts payable turnover ratio measures how quickly a company pays its suppliers, indicating its short-term liquidity and efficiency.
An earnings call is a conference where a public company's management discusses financial results and answers questions from analysts and investors.
Proof of funds is a document verifying financial capability for large transactions like home purchases.