Updated July 25, 2023
Introduction to Subprime Loans
Subprime loans are loans offered to individuals at a higher rate above the prime rate who do not qualify for prime rate loans either because of a lower credit rating assigned to them, low income, high loan to value ratio, or other factors which indicate that they will default on their debt obligation.
The investors in traces created from subprime mortgage loans have no guarantee of interest and principal repayment.
The term “subprime loan” refers to the type of loan offered to individuals who don’t qualify for conventional loans because of their low income, inability to offer high-quality collateral, limited or poor credit history, etc. Accordingly, these loans are offered at an interest rate that is significantly above the prime rate. The option of subprime loans is available across different types of loans, such as personal loans and auto loans. In the case of subprime loans, the lenders primarily focus on the ability of the borrowers to repay the loans rather than their weak credit scores.
Lenders generally offer Subprime loans when the borrower fits into the below criteria:
- Lower FICO scores, i.e. below 660
- Higher debt to income ratio
- Higher debt to asset ratio
- Foreclosure in the last 24 months
- Near to bankruptcy
- Greater obligations such as living expenses, children expenses, and education expenses
How do Subprime Loans work?
There is no defined cut-off for credit scores for extending conventional loans. However, people with a credit score of less than 600 usually don’t get a conventional loan that easily. This is where subprime loans come into play where they assist these people with poor credit histories to get access to funds to finance their needs. Basically, these borrowers possess the financial capability to repay the loans but don’t have the required healthy credit score.
Individuals with good credit scores and strong credit histories usually secure mortgages, car loans, and small business loans at interest rates slightly above the prime rate. On the other hand, applicants with low credit scores are offered interest rates that are way above the prime rate, hence the name “subprime loan.”
Characteristics of Subprime Loans
A typical subprime loan exhibits some or all of the following distinct characteristics:
- The borrowers are new businesses, retirees, or self-employed individuals.
- Many of the borrowers belong to the lower-income group.
- The credit scores of the borrowers are usually less than 600.
- The debt-to-income ratio of these loans is greater than or equal to 0.5.
- The borrowers possess poor credit histories with instances of delayed credit cards or loan payments.
- The borrowers may have gone bankrupt once in the last 5 years.
- The borrowers had a foreclosure in the last 2 years.
Types of Subprime Loans
There are four main variants of subprime loans, which are mentioned below:
1. Interest-only Loans
In this type of loan, the borrowers need to pay only the interest part during the initial period, making the loans more affordable in the early days. However, the monthly payments witness a steep increase in the later periods as the principal payment kicks in.
2. Fixed-rate Loans
In this type of loan, the interest rate remains constant for the entire duration. The tenure for these loans is usually longer than the conventional loans, which is around 30 years. The tenure of fixed-rate loans may run up to 50 years. Hence, the aggregate interest paid tends to be huge in the case of fixed-rate loans.
3. Adjustable-rate Loans
In this type of loan, the interest rate remains fixed for the initial period and then later changes to a variable rate. The interest rate of the loan varies according to the movement in the market rate.
4. Dignity Loans
In this type of loan, the borrowers need to make a down payment of 10% of the loan amount and accept a higher interest rate for the initial period of the loan, usually five years. If the payments are made on time, the lenders may choose to reduce the interest rate to the level of the prime rate.
Reasons for Subprime Loan Crises in 2007-2008
Reasons for Subprime Loan Crises in 2007-2008 are given below:
1. The main Driver was Profit Making
Their knowledge influenced the behavior of mortgage originators that mortgagees will be securitized. When considering new mortgage applicants, the main driver was not a credit rating assigned to these investors; rather, it was whether it could fetch huge money.
2. Lack of Tools Available to Assess Credit Rating
when mortgages were securitized, the only information about the mortgages by the buyers of the products that were created from them was a loan to value ratio (the ratio of the size of the loan to the assessed value of a house) and the borrower’s FICO ratio. Other information on the mortgage application form was considered irrelevant and often not even checked by lenders. The lender’s most important thing was whether the mortgage could be sold to others, which depended largely on the loan to value ratio and the applicants’ FICO score.
3. No Independence to Property Assessors
Subprime loans were mostly backed by house property. Passing both loan to value ratio and FICO score was doubtful quality. The property assessors who determined the value of the house at the time of the mortgage application were pressurised by lenders to come up with a high value. Potential borrowers were sometimes counseled to take actions that would improve their FICO scores.
4. Regulatory Requirements were Relaxed
US government had since 1990 been trying to expand homeownership and had been applying pressure to mortgage lenders to increase loans to low- and moderate-income people, which lead to a drastic increase in subprime loans.
5. Fake Application Forms
One of the terms used to describe subprime loans was liar loans because individuals applying for loans were aware that no checks would be carried out and hence chose to lie on the application form.
6. Lack of Knowledge of Rating Agencies
Rating agencies have moved from the traditional form of bond rating to structured products that are highly dependent on default correlation between the underlying asset, which was relatively new and little historical data was available.
7. Lack of Knowledge of Investor
The product bought by investors was complex, and both investors and rating agencies have incomplete and inaccurate information about the quality of underlying assets.
8. Risks Involved in Subprime Loans
Subprime loans carry greater risks as compared to other conventional loans. There is a lower probability of capital repayment by the borrower, and hence lenders charge higher interest rates to compensate for higher risks. On the other hand, the borrower has more probability of default if additional fees and interest are levied.
9. Higher Fees Levied
Origination fees and upfront service charges are significantly higher in subprime loans as compared to conventional loans. Lenders often charge these rates in the form of higher monthly installments. Late payment fees are also higher.
Example of Subprime Loans
The widespread defaults on subprime mortgages were largely responsible for the housing market crash or subprime crisis of 2008. Most of the borrowers were offered highly risky loans which were known as NINJA loans, an acronym for the phrase “no income, no job, and no assets.” These NINJA loans are prime examples of how subprime loans can go absolutely wrong.
These subprime loans were often issued without any down payments or authentic proof of income. Borrowers could state earnings of $100,000 annually without providing any proof to substantiate the claim. These borrowers later found themselves in deep trouble as the housing market crashed and the values of their homes fell below their mortgage liabilities. Many of these borrowers defaulted because the interest rates started low but ballooned over the period, making it extremely difficult for them to cover the payment obligations later.
Difference Between Prime Loan and Subprime Loan
- The federal reserve bank decides interest on the prime loan, i.e. fed funds rate is the rate at which renowned banks borrow and lend from each other, which is fixed in nature. However, subprime loans vary as per the attributes of different lenders.
- Subprime loans are often taken on auto loans, home loans, education loans, revolving loans, personal loans, and small-scale business loans, which are very risky in nature as compared to prime loans, which are taken by large financial institutions, and big corporates with higher credit ratings.
- Subprime borrowers do not have strong credits histories, which include loan defaults, lack of possession of assets or property which can be used as collateral, they have been a record of missed payments on credit cards or other existing loans or an outstanding legal judgment against the individual whereas Prime loans have stronger financial status.
Benefits of Subprime Loans
- Borrowers with poor credit scores can get access to subprime loans of many different types, such as mortgages, personal loans, and auto loans.
- These loans can help in consolidating existing debts and managing their payments in a better way.
- Borrowers making timely payments on subprime loans can improve their credit scores in the long run.
Disadvantages of Subprime Loans
- The lenders charge higher interest rates for subprime loans to offset the higher credit risk.
- Predatory lenders often charge uninformed borrowers extremely high-interest rates and other fees.
- Subprime loans are loans offered to individuals with weak credit histories and poor credit scores, people who are more likely to default on a loan.
- The lenders offer subprime loans at interest rates that are significantly higher than the prime rate.
- There are four different types of subprime loans – interest-only loans, fixed-rate loans, adjustable-rate loans, and dignity loans.
So, subprime loans are issued to people who are more likely to default or miss the repayment schedule due to a variety of reasons. The subprime crisis of 2008 clearly shows how these loans can lead to catastrophic economic problems. Thus, it is important that these loans are monitored closely and the right actions are taken at the right time to prevent any financial fiasco.
Many financial institutions do not provide Subprime loans due to an extra layer of credit risks involved in the event of default, thereby increasing the interest rates chargeable on these loans. But however, just increasing the interest rate won’t solve the problem as it may put more financial pressure on the borrower.
This is a guide to Subprime Loans. Here we discuss the definition, working, characteristics, types, reasons, and examples along with the advantages and disadvantages. You may also look at the following articles to learn more –