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 tܫheir low credit ratings or oth෴er factors that suggest they have a reasonable chance of defaulting on the debt repayment.

How a Subprime Loan Works

When banks lend each other money to cover their reserve requirements, they charge each other the prime rate, an interest rate based on the 澳洲幸运5官方开奖结果体彩网: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 澳洲幸运5官方开奖结果体彩网:prime rate has fluctuated from a low of 2% in the 1940s to a high of 21.5% in the 1980s. At its Dec. 18, 2024 澳洲幸运꧒5官方开奖结果体彩网:Federal Open Market Committee (FOMC) meeting, the Federal Reserve lowered the target range for the fed funds rate by 0.25%. This action was the result of the Federal Reserve's efforts to combat persistent inflation. 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 7.5% based on the Fed's latest action, as of this writing.

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 facto♒rs are offered rates by lenders that are significa𒈔ntly higher than the prime rate—hence the term “subprime loan.”

The specific amount of interest charged on a subprime loan is not s൲et 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 advertisement for mortgages when they actually qualify for a better rate than they are offered when they follow up on the ad. Borrowers should always൲ check to see whether they qualify for a better rate than the one they are originally offered.

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 ensuing 澳洲幸运5官方开奖结果体彩网:Great Recession. As a result, several big banks got out of the subprime lending business. More recently, though, this has 澳洲幸运5官方开奖结果体彩网:started to change.

While any financial institution could offer a loan with subprime rates, some lenders focus on 澳洲幸运5官方开奖结果体彩网: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 澳洲幸运5官方开奖结果体彩网:predatory lending, which involves giving borrowers loans with unreasonable rates, locking them into debt, or increasing their likelihood of defaulting. Nevertheless, getting a subprime loan may be a sensible option if the loan is 𒈔meant to pay off debts with higher interest rates, such as credit cards, or if the borrower has no other means of obtaining credit.

The Bottom Line

Subprime loans are a legitimate mortgage option for people who might otherwise not qualify for a mortgage. Although the interest rates and upfront fees are higher, it borrowers consistently make their mortgage payments, they can see an improvement to their cr꧋edit scores.