What you Need to Know about Subprime Loans

When the housing market collapsed in the United States back in 2007, the blame was placed squarely on the practice of banks doling out subprime loans and mortgages. The word has since taken on a particularly negative connotation, but what does it actually mean? And is it really as bad as the news would have you believe?

What it is:

Simply put, subprime loans are for people trying to borrow money who A) have a low credit score, B) have low income and/or difficulty maintaining a repayment schedule or C) have no credit score (and as such, banks have no reason to trust that they will make payments in full and on time). Factors A and B often (but not always) go hand in hand and subprime borrowers typically have to agree to higher interest rates and harsher loan terms.

By contrast, prime lending refers to borrowers who have an excellent credit history and, as a result, are given lower interest rates and better loan terms because banks believe they are likely to make payments in full and on time.

Subprime lending can apply to many different types of loans, but the term is most commonly used in conjunction with auto and mortgage. Some other terms used synonymously with ‘subprime’ are near-prime, non-prime, or second-chance lending.

One of the biggest myths about subprime loans is that all eligible borrowers have terrible credit histories. While this is definitely true for some, in a lot of cases borrowers actually have no real credit history (meaning there is no source of tangible evidence banks can use to gauge how likely they are to get their money back.) Some key examples of these types of borrowers are students or recent graduates, people in their early twenties, or even people who are married but who don’t have any loans or credit taken out under their own names.

Subprime Stigma vs Reality:

The first introduction many had to the term ‘subprime’ was in direct association with the aforementioned subprime mortgage crisis of 2007. While the crisis is technically the fault of the lenders rather than the borrowers, the word ‘subprime’ took on a bad name in the eyes of many.

While it’s obviously not ideal for the borrower or the lender to engage in a subprime loan, there are definitely some key positives. People who are forced to take on a subprime loan but who manage to make their payments on time and avoid penalties can start building their way to a better credit score. In addition, keeping the market open to subprime lending means that people who would normally never have access to the credit market now do. Subprime lending means that everyone who would have been excluded in the past are now able to buy a home or a car.

How to tell if you’re a Subprime Borrower:

The first step is to request a copy of your credit history. Your credit score will be the key deciding factor. A credit score of 670 or below used to be the threshold at which subprime rates were offered, but that’s slowly started to change (meaning you should ask for clarification just to be sure).

You also want to make sure to comb through your credit history to make sure everything is in order and accurate. Credit bureaus aren’t perfect, and it’s fairly common for them to make mistakes. Make sure you’re not being penalized (and that your credit score isn’t suffering) because of someone else’s error.

And if You Are?:

If you discover that you are a subprime borrower, then the best thing you can do is put plans in motion to clean up and boost your credit score. Make sure you’re making at least the minimum payments on everything you owe and make sure that any errors in your credit history have been corrected.

If you’re planning on taking out a loan before you have time to boost your credit score, then make sure to get pre-approved financing through a bank (this applies especially to auto loans). By knowing exactly how much money you’ll be eligible for – and at what terms – before you even step foot in a dealership, you eliminate the chances of being turned down for financing at the dealership (Dealerships typically only give auto loans to prime borrowers).