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.
Key Takeaways
- Subprime loans have interest rates that are higher than the prime rate.
- Subprime borrowers generally have low credit ratings or are people who are perceived as likely to default on a loan.
- Subprime interest rates can vary among lenders, so it’s a good idea to shop around before choosing one.
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, an interest rate based on the federal funds rate established by the Federal Open Market Committee of the Federal Reserve Bank. As the Fed's website explains it, "Although the Federal Reserve has no direct role in setting the prime rate, many banks choose to set their prime rates based partly on the target level of the federal funds rate—the rate that banks charge each other for short-term loans—established by the Federal Open Market Committee."
The prime rate has fluctuated from a low of 2% in the 1940s to a high of 21.5% in the 1980s. At its March 15, 2020, Federal Open Market Committee (FOMC) meeting, the Federal Reserve lowered the target range for the fed funds rate to 0%–0.25%. This action was the result of the Federal Reserve's efforts to combat the economic repercussions of the COVID-19 pandemic. Since the 1990s, the prime rate has typically been set to 300 basis points above the fed funds rate, translating to a prime rate of 8.5% based on the Fed's latest action, as of this writing.
4.25%
The U.S. prime rate in March 2020
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 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 lending market by, for example, responding to an advertisem*nt 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.
The higher interest rates on subprime loans can translate into tens of thousands of dollars in additional interest payments over the life of a loan.
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 borrowers, as it did in the late 2000s. In 2007, high numbers of borrowers holding subprime mortgages began to default. Ultimately, this subprime meltdown was a significant contributor to the financial crisis and the ensuingGreat Recession. As a result, a number of big banks got out of the subprime lending business. More recently, though, this has started to change.
While any financial institution could offer a loan with subprime rates, there are lenders that focus on second-chance loans and subprime 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.
Subprime lending is often considered to be predatory lending, which is the practice of giving borrowers loans with unreasonable rates and locking them into debt or increasing their likelihood of defaulting. Nevertheless, getting a subprime loan may 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.
