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What are Subprime Loans?
The term Subprime Loans or Subprime lending refers to the practice of issuing loans to those people who are financially backward or who have a higher probability of missing the repayment schedule due to various uncanny situations in business, work or life. These situations may well include cases of divorce, unemployment, medical emergencies etc. or any other similar setback that has the power of disturbing the borrower’s ability to serve the debt. The loans made keeping the risk involved with such borrowers are called as subprime loans.
Earlier in 2007, the US and in turn the global economy was hit hard due to subprime crisis (related to mortgage loans). After a decade of such a big financial mess, looks like there is another subprime loan crisis in the offing and this time in the “Auto Loan segment”. Equifax pointed out that car loan delinquency levels have increased to levels seen in 2007.
In this article, we discuss Subprime Loans in detail –
- Subprime Loans Introduction
- Prime rates & sub prime rates
- Credit Rating and Subprime Loans
- Types of subprime loans
- Subprime loan lenders
- Advantages of subprime loans
- Disadvantages of subprime loans
- Subprime Crisis of 2007-08
- Next Subprime Crisis
Subprime Loans Introduction
Subprime lending is also called by other commonly used names like near-prime lending, nonprime lending, and second-chance lending. The main difference between a normal lending (or prime lending) and a subprime loan is the high-interest rate of the latter as compared to the former one. This high-interest rate, characteristic of subprime loans, is necessary to compensate for the high credit risk that they bear.
Prime rates & sub prime rates
Prime rate refers to the fixed interest rate decided by the federal reserve bank of the country against the prime loans provided by financial institutions. Unlike the prime rate, the subprime loan rates are not fixed. They keep changing based on different lenders.
The prime loans are issued among banks or to big industries and have the lowest rates of interest at which money may be borrowed commercially. The interest rate applicable on prime loans is relatively fixed in nature.
And it is based on this rate that the banks decide what rate to charge from its borrowers. Thus, those borrowers, who take loans, like auto loans, home loans, personal loans or other small business loans, usually get an interest rate slightly higher than the prime rate. This is because such loans have a somewhat higher risk than the prime loans.
Finally, when it comes to subprime loans, the interest rate will be significantly higher than the prime rate as the credit risk is also very high for them.
Credit Rating of SubPrime Lending
The term credit rating refers to the calculation of a borrower’s credit level or financial status based on different records, which may include records related to the history of his borrowing, lending and earning. The term “subprime” refers to those borrowers who have a low credit rating or who have a weak history of credits, which may make them more probable to end up in a loan default than the prime borrowers. A financial institution has the rights to check for any records of a borrower applying for a loan and to find out whether they are eligible for a prime loan or a subprime loan. Subprime loan borrowers may have credit histories, which may include:
- Unpaid debt or a history indicating failures to pay debt, which ended up in loan defaults.
- Have no property or assets in their possession, which can be used as security against the loan.
- Excessive debt, which can be referred to as a situation, wherein the individual or his family has an income, which is not enough to meet the loan payment, interest and their living expenses together.
- A record denoting any missed payments for debt, which had made the loan period to be extended.
- Any legal judgements against the individual, which include orders to pay or file bankruptcy.
More than these records, there can be other factors, like the size of the loan, the type of the loan, the repayment model structure and other aspects. These, in total, can even make a borrower with prime characteristics to be classified as subprime.
Types of subprime loans
Subprime loans can be classified into four different types which are as follows:
- Adjustable rate subprime loans: These are loans, which will have a fixed interest rate primarily, and in a later stage, this rate may be changed to floating. A 2/28 loan can be taken as an example in this case. In his type of loan, there is a fixed interest rate for the first 2 months of a 30 month long repayable loan, and after the initial 2 years, the rate will get variable. The floating rate will be determined on the basis of different indices. In general, after the first few periods of a flat rate of interest, the interest rate may shoot up or increase gradually. However, there are loans, in which the interest rate will go on decreasing with time. In this type of subprime loans, there is generally an additional option for the borrower, wherein he can increase his credit score before the end of the flat rate period.
- Fixed rate Subprime loans: In this type of subprime loan, there is a fixed but higher rate of interest. This type of loans usually has a longer repayment period, which may range between 40 and 50 years, unlike the normal 30 year period. This long term repayment model of this loan helps the borrowers with a low monthly payment as compared to the installments of the loan. However, the interest rates will be higher than most other types of loan.
- Interest only Subprime loans: This is a type of subprime loans, in which the payment of interest amount and the principal amount is divided into different periods. Initially, there will be a five, seven or 10 year period, in which the borrower will only pay interest amount. Then, after this period, the borrower will start paying back the principal amount of the loan. Many times, the borrower also has an option to pay the principal amount at the initial period if possible, but this is not mandatory in this type of subprime lending. This type of loans will be useful for borrowers having fluctuating earnings.
- Dignity Subprime loan: This is a new type of subprime loan. In this type of loan, the borrower has to pay a small down payment, which will equal to almost 10 % of the principal amount of the loan. And after the down payment, the borrower has to pay the instalments at a higher interest rate for a specified period of time. If the payments are done correctly during this period of time, the balance amount of the loan is again calculated, and then on, the interest rate goes on decreasing to equal the prime rates at one point of time.
Any type of financial institutions can give out subprime loans. But most institutions are not ready to take up the risks related to subprime lending and they only consider borrowers with prime characteristics, neglecting those who cannot get prime loans.
However, there are institutions, which focus only on those borrowers who cannot be considered as prime borrowers. Many of these organizations are targeted towards charging high rates in the name of subprime lending, which makes it difficult for their borrowers to repay, which eventually gets them into a state of loan default, affecting their credit ratings badly.
When most of the financial institutions thoroughly check the credit scores or the financial background of its borrowers, many borrowers lose access to prime loans. Not everyone will have enough assets or a clean financial historical record, which is what most banks need to consider before approving a loan.
- For such cases, these borrowers can opt for the subprime lending market. In the subprime loan market, anyone, who is not considered eligible to get a prime loan, can get a subprime loan, although at a much higher interest rate. In the subprime market, credit ratings need not be perfect to obtain a loan.
Subprime lending can be seen as a nice way to maintain or increase an individual’s credit score too. Debts not paid can seriously affect one’s credit score, and having such debts in their historical records will make them ineligible to obtain a prime loan.
- In such cases, a borrower can opt for a subprime loan, which does not require much credit score and use this loan amount to pay off the previous debts that he was finding difficult to repay. This loan can be paid off in the coming years and this will decrease the chance of the borrower running into a bad credit score. So subprime borrowing is a great way to fix a borrower’s credit score.
- Subprime loan borrowers, as well as lenders, are prone to greater risks compared to the prime loan borrowers.
Interest rates can be a great resource to identify the amount of risk associated. As subprime lending has more credit risks than that of prime lending, the institution will make this credit risk up by significantly increasing the interest rate. As the interest rate is high, the chances of a borrower running into the state of loan default are also high.
- Subprime loans are said to have more initial processing fees than prime loans. As the amount of credit risk is high in subprime lending, the institutions need to prepare a lot of documentations and follow other additional procedures, which shoot up the initial processing fee.
- Although subprime loans are said to be something supporting people who are not capable of getting a prime loan because of a low credit score, there are certain income demands included in this.
The financial institutions may not consider credit scores of the borrower but they do make sure whether the borrower has enough regular income or cash flow to pay back the loan amount within the specified time or not. This is done by various documents or through a background check. If a borrower cannot prove that he or she has enough income to pay back the loan amount in good time, he or she will not be considered even for a subprime loan.
Subprime Crisis of 2007-08
The Subprime loan crisis is a phenomenon that took place in the USA in the year 2008. It had led to a country-wide recession and a nationwide banking emergency.
The subprime loan crisis arose from ‘bundling’ together of the subprime and regular loans with mortgage backed securities (MBS) that were normally isolated from, and sold in a separate market from, the prime loans. These ‘bundles’, which were a combination of prime and subprime loans, were based on asset-backed securities. Therefore, the expected rate of return was excellent because subprime lenders were charged with higher premiums on loans that were, in turn, secured against highly marketable real-estate. All these “back-ups” made the professionals believe that this scheme can never fail (just like the Titanic).
Several subprime loans had a low interest for the initial few periods, and poorer consumer defaults were ‘swapped’ often initially. But finally, all such borrowers began to move into a state of default in large numbers. The inflated house-price bubble burst, property valuations plummeted and the real rate of return on investment became unable to be calculated. As a result, confidence in these instruments (the bundles) collapsed, and every loan, other than prime loans, was considered to be almost a valueless and value eroding asset, despite their actual composition or performance.
Subprime mortgage originations grew from $173 billion in 2001 to a record level of $665 billion in 2005, which represented an increase of nearly 300% as shown in the figure below:
Due to the “originate-to-distribute” model, followed by several subprime loan originators, there was little monitoring of credit quality and small effort made for remediation as these subprime loans became troubled. As most borrowers were terrified by the high initial payment rate, many chose to get the interest rates adjusted, which made them pay a low-interest rate initially. But the annual increase in the rate was not considered seriously by most of the borrowers and the adjustment made annually was a minimum of 2%.
So if we consider a case, wherein the loan amount is $5,000,00 with an interest rate of 4% for a duration of 30 years, the initial payment will be a little less than $2400 a month. Now, let us consider that after 3 years the flat rate period ends and now the rate of interest is 10% for the remaining 27 years. This will make the payment to be done to be more than $4200 a month. As we have seen an increase of 6 percentage points in the rate of interest, it has made a significant increase of 75% in the installment to be paid each month. So this increase was not considered initially by the borrowers, which made them end up in a difficult situation. And finally, most borrowers defaulted on their subprime loans which eventually led to the nationwide failure of the banking system.
Next Subprime Crisis?
After a decade of 2007-08 subprime crisis, it seems that the Banks have failed to learn and now the subprime crisis is engulfing the Auto segment too.
Subprime Crisis in Car Loans work like this –
- In order to increase the sales, the car dealers in collaboration with the banks, provide new vehicles loans to lower income people (even with poor credit ratings)
- Banks are happy to increase their loan books by approving such car loans without doing much due delingence of buyers ability to pay.
- Investment Bankers aggravate the situation by buying such thousands of auto loans and bundles them and make them “Exotic” offering higher returns.
- Wealthy investors and speculators hop on to such exotic schemes
Bloomberg reports pointed out that banks sold $26 billion worth of these explosive bundles of car loans.
Articles related to next subprime crisis –
- US Goes Subprime All Over Again
- You can now buy $400 pants with a subprime loan
- ‘Deep’ Subprime Car Loans Hit Crisis-Era Milestone as Woes Mount
As we have seen in the above article, the subprime loans can be very helpful to those who have a low credit score which prevents them to get the normal loans. The high credit risk associated with the practice of subprime lending has made most of the financial institutions and banks to stop considering such borrowers and they provide only prime loans.
But since the prime loans are only provided to those with a minimum credit score, individuals who are with a low credit score and in need of money don’t have that option. Therefore, subprime loans have helped a lot of individuals in such cases to get a loan, although most institutions have significantly high interest rates when compared to prime rates.
A big challenge arises when institutions in the subprime market target to charge extraordinarily high rates, making the borrowers’ chances of running into default high. But in a situation in which a borrower has a low credit score but needs to borrow money, there is no other legal and viable option, better than getting a subprime loan.
The best one can do is to select the type of subprime loan which suits his financial situation. One can also use the subprime loans to improve his credit rating by repaying the previous problematic loans. However, one should not just consider the initial payment periods but should pay heed to all the terms and conditions over the full life of the loan.
Other Recommended Articles
This has been a guide to Subprime Loan, types of subprime loans, its advantages and disadvantages. You may also have a look at the following articles for enchancing your knowledge on fixed income.