A subprime loan is a type of loan offered at a rate above prime to individuals who do not qualify for prime-rate loans. Often, subprime borrowers have been turned down by traditional lenders due to their low credit ratings or other indicators suggesting a higher chance of defaulting on debt repayment.
Key Takeaways
- Subprime loans carry interest rates higher than the prime rate.
- Subprime borrowers generally have low credit ratings or are perceived as possible defaulters.
- The interest rates on subprime loans can differ among lenders, making it essential to shop around before committing to one.
How a Subprime Loan Works
When banks lend each other money to meet reserve requirements, they charge the prime rate, an interest rate based on the federal funds rate established by the Federal Open Market Committee of the Federal Reserve Bank. Although the Federal Reserve does not directly set the prime rate, many banks base their prime rates on it, influenced by the federal funds rate.
The prime rate has varied historically, reaching a peak of 21.5% in the 1980s and dropping as low as 2% in the 1940s. In response to the COVID-19 pandemic, the Federal Open Market Committee lowered the federal funds rate target range to 0%-0.25% in March 2020, leading to a prime rate of approximately 4.25% at that time. The prime rate significantly influences the interest rates that banks charge their borrowers.
Borrowing Landscape
- Corporations and financial institutions typically enjoy rates equal or very close to the prime rate.
- Retail customers with good credit receive rates slightly above the prime rate for mortgages, small business loans, and car loans.
- Applicants with low credit scores or other risk factors are offered rates significantly higher than the prime rate, known as ‘subprime loans.’
Interest rates on subprime loans aren’t fixed, as different lenders evaluate risk differently. It is advisable to shop around to potentially secure a better deal. Borrowers may unknowingly enter the subprime market through enticing advertisements, highlighting the need for consumers to confirm if they qualify for better rates.
Special Considerations for Subprime Loans
For long-term loans like mortgages, the extra interest from subprime loans can amount to tens of thousands of dollars over the loan duration, making them challenging to pay off for lower-income borrowers. This was evident in the late 2000s when numerous subprime mortgage holders defaulted, contributing significantly to the financial crisis and the Great Recession. Consequently, major banks pulled out of the subprime lending sector, though some re-entry has been noted in recent years.
Institutions focusing on subprime lending or ‘second chance loans’ enable borrowers with poor credit ratings to access capital for investments, home purchases, or business growth. However, this sector is sometimes criticized as predatory lending, imposing unreasonable rates that may entrap borrowers in debt or increase default risks. Despite controversies, subprime loans may be reasonable if used to pay off higher-interest debts, like credit cards, or if no other credit options are available.
Related Terms: prime rate, federal funds rate, mortgages, credit risk, predatory lending
References
- Federal Reserve Board. “FAQ’s: What is the Prime Rate, and Does the Federal Reserve Set the Prime Rate?”.
- Federal Reserve Bank of St. Louis. “Bank Prime Loan Rate Changes: Historical Dates of Changes and Rates”.
- Federal Reserve Board. “Press Release March 15, 2020: Federal Reserve Issues FOMC Statement”.
- U.S. Securities and Exchange Commission. “RSA 399-B Statement of Finance Charges”.
- Federal Reserve Board. “Selected Interest Rates (Daily) - H.15”.
- Federal Reserve History. “Subprime Mortgage Crisis”.
