What is Subprime Lending?

October 27, 2020

This loan type is usually offered to individuals who do not meet the criteria of prime-rate loans. Prime-rate loans refer to loans issued by companies that are offered to corporations who are considered to be credit-worthy. It is often the case that individuals who secure subprime loans have been rejected by traditional financial institutions because of their unsatisfactory credit ratings and other factors.

 

How Prime Rates and Subprime Lending Works

The rate that are ultimately offered on subprime loans are somewhat influenced by the interest rate offered on prime loans. The interest rates offered on prime loans are based on the Federal funds rate. This rate was established by the Federal Reserve Bank’s Federal Open Market Committee. Banks usually lend each other money based on this interest rate. 

In an effort to combat the economic impact of the COVID-19 pandemic, the Federal Reserve reduced the target range for the Federal funds rate to 0% to 0.25%. Historically, the prime rate has been set to 300 basis points above the rate set by the Federal Reserve. This means that the prime rate is about 3.25% since the passing of the COVID-19 strategic financial measures.

Prime rate ultimately influences the interest rates that borrowers receive from banks. It is normally the case where corporations and other financial institutions benefit from rates that are similar are equivalent to the prime rate. Other forms of loans such as mortgages, small business loans, and car loans are issued at higher rates than the prime rate; however, these rates are influenced by the prime rate. Loan applicants with unfavorable credit history and other undesirable factors receive rates that are much higher than the prime rate. This is where the phrase “subprime” comes from.

There isn’t a set rate for subprime loans. Different lenders have different criteria and judgment that they use to determine the interest rate that they will offer on a subprime loan. This means that an individual in search of a subprime loan should do some amount of shopping around to find the rate that is right for him or her.

 

Final Thoughts

Maintaining a positive credit report and great credit score is key to affordable borrowing; however, there are cases where bad financial decisions cause great damage to one’s credit history. When these things happen, you may end up being forced to negotiate a subprime loan. It is important that you do all that is necessary to avoid taking out large loans at subprime rate.

Large subprime loans can be difficult to repay for low-income borrowers. The risk of taking out a large subprime loan such as a mortgage as a low-income borrower is best captured by what took place in 2007. That year, a number of subprime loan borrowers who held mortgages started to default. Experts suggest that this was a major contributing factor to the financial crisis and the Great Recession of 2008.

Rahul Iyer

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