Subprime Loans: What You Need to Know
If you remember the events leading up to the Great Recession, you probably have at least heard of subprime mortgage loans. Subprimes played a major part in creating the housing bubble that led to the financial crisis and were even featured prominently in the plot of 2015’s The Big Short (a comedy/drama about the crisis). But what is a subprime loan? Do these loans even still exist?
Well, the answer to this question is a little complicated. While you’re not likely to hear lenders use the term “subprime loan” or “subprime mortgage” these days, you can still find loans that are most definitely subprime. If you have less-than-perfect credit, there’s a decent chance you might even encounter them while shopping around for a mortgage. To help you make a more informed decision, here’s what you need to know about subprime loans and how they could affect your financial future.
What Is a Subprime Home Loan?
First things first … just what is a subprime home loan, anyway? At its most basic, a subprime loan is a loan product that is issued to someone who’s not an ideal loan candidate. Many subprime borrowers have low credit scores and may have other risk factors as well, such as a difficulty maintaining an income sufficient to meet the payment schedule. As a result, there is a much higher risk that the borrower will default on the loan.
Here are just a few of the problems that a subprime borrower might have:
A credit score under 600 (though some lenders consider scores under 640 to be high-risk)
A history of late or missed payments on existing loans or credit products
Excessively high levels of debt, possibly above what the borrower can reasonably maintain
A history of defaults on loans or credit products
Little or no collateral of enough value to secure a loan
Legal judgments or bankruptcies that have not been discharged
For most mortgages or other loans, these borrowers simply wouldn’t qualify and that would be the end of it. Subprime lenders take a different approach. Instead of denying potential borrowers who fail to meet the normal loan criteria, they offer loans with higher interest rates and less favorable terms to help ensure that they still make money off of the loan.
While specific loan details will vary, that’s the core of what a subprime loan is: It’s a loan designed for people who otherwise might not qualify. The terms of the loan are very clearly in the lender’s favor since there’s no guarantee that the borrower will repay the loan in full.
You can probably see where this might cause problems.
The Subprime Mortgage Crisis
During the early 2000s, subprime loans were very popular as a way to let borrowers with credit problems buy homes. The economy was doing well enough, the housing market was up, and some lenders and investors realized that there was a lot of money to be made in the subprime lending market. Subprimes became much more common and were often bundled together with prime loans in mortgage-backed securities for investors. These investments fed more money into the subprime market, driving housing and construction growth even though they were based on a significant amount of risk. How bad could subprimes actually be, though?
The answer, of course, was very very bad. By the mid-2000s, subprime mortgages had created a housing bubble supported by high-risk borrowers and unsustainable interest rates. The people who were making the most money off of subprime lending obviously wanted to make more money, so no one really looked at the state of the housing market and these subprime loans until it was too late.
When the bubble burst, it nearly took the economy down with it. The federal government had to step in to stem the tide, and economies around the world felt ripples of the financial crisis due to their investments in U.S. markets. The Great Recession that followed the crash lasted for the better part of a decade. In the aftermath, people finally started to realize just how dangerous rampant subprime lending could be.
But that wasn’t the end of the story.
Subprime Regulation
After rampant subprime lending and mortgage-backed securities crashed the housing market and set off the Great Recession, the federal government passed laws to regulate these loans and rein in some of the predatory lending practices that took advantage of subprime borrowers. Many assumed that this increased banking regulation would eliminate the majority of subprime loans altogether, especially in the mortgage market. That didn’t happen, but efforts were made to control the way the lending industry used subprime loans.
One part of the response to the subprime mortgage crisis was the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Act targeted a number of causes of the financial crisis of 2007, including out-of-control and predatory lending practices. New regulations for banks and Wall Street were put in place, and a new independent bureau known as the Consumer Financial Protection Bureau (CFPB) was created to provide additional protections for borrowers and homeowners.
The CFPB has the ability to create and enforce rules for banks and other financial institutions, while also monitoring financial markets and tracking consumer complaints within the financial industry. Though its jurisdiction is fairly broad in scope, the CFPB’s main regulatory priorities are mortgage lending, student loans, and credit cards. This is significant, as all three of these areas have been abused by predatory lenders offering subprime products in the past.
The CFPB hasn’t been a hit with everyone, of course, and there have been a few claims that its jurisdiction is too broad and its activities might harm the financial sector more than they help. The Bureau’s structure has also been criticized for placing too much power into the hands of a single director instead of spreading it out across multiple individuals. These criticisms and other political pressures have resulted in the reduction or elimination of some of the CFPB’s powers; notably, automotive lending rules have been repealed, and a number of banks were given exemptions from CFPB regulation.
The Status of Subprime Loans
As mentioned earlier, a lot of people thought that regulatory changes after the subprime mortgage crisis would end subprime lending entirely. It didn’t, and that’s not necessarily a bad thing. Some subprime loan products have the potential to be positive, especially for those who are attempting to recover from unexpected hardships but have the means to repay their debt over time. Subprime loans took a lot of heat as a cause of the financial crisis and Great Recession, but a lot of the problem there was tied in with how the loans were used and not just the fact that they existed.
You only need to look at the student loan market to see how there is still a place for subprime loans, as long as they aren’t abused. Most college students don’t have the credit history required to qualify for high-quality loans, so the majority of student loans are actually considered subprime. In some cases, there may be a cosigner or federal insurance to cover the risk associated with the loans, but there’s still no guarantee that students will be able to repay their student loan debts after they graduate. Predatory lenders have targeted these students with high interest rates and unfair terms in the past, giving a good example of how the problem isn’t necessarily in the loans themselves but in the way that lenders choose to offer them.
Credit cards are another area where subprime offers once ran rampant. Cards for individuals with bad credit were once available from a number of less-than-reputable lenders, typically including numerous fees and a very high interest rate. Some of these cards had so many fees that just taking out the card used up 50 to 75% of the cardholder’s available credit, and in some cases, the card wouldn’t even be usable until the first payment was received. Cards for people with less-than-perfect credit still exist, though fewer lenders offer them these days and they no longer have some of their worst traits.
What about mortgages, though? The effect on the housing market of rampant subprime lending was one of the big contributors to the financial crash, so it might make sense if subprime lending was eliminated for something as significant as homeownership. You might be surprised to learn that this isn’t the case.
The Modern Subprime Mortgage
Most likely, you won’t hear the term “subprime” from potential lenders if you’re shopping for a mortgage loan. There’s still a significant stigma attached to that term, even if subprimes themselves weren’t explicitly the cause of the financial crisis. There are a few other terms that you might hear these days, including the term “nonprime” loan.
Part of the reason that these mortgages are gaining in popularity is that the federal government has slowly relaxed its requirements regarding home loans. Borrowers are allowed to have a higher amount of debt in relation to their income (known as a debt-to-income ratio, or DTI); this means that you could qualify for loans today that you may not have qualified for just a few years ago. Credit score requirements didn’t change, but these regulatory changes did open the door for the normalization of loans that would have seemed out of place during the Great Recession.
These “nonprime” loans undergo more scrutiny than the subprimes of the past, but some allow for credit scores as low as 500. Larger down payments may be needed, and interest rates will certainly be higher than what you’d find with prime loans, but they aren’t as likely to be abused by predatory lenders as they were in the past.
Of course, it’s worth keeping in mind that even with less abuse you still might end up getting a bad deal on a subprime or “nonprime” loan. Lenders can still offer subprime variants of loans that aren’t in your best interest, including so-called “interest only” loans, 40-year mortgages and some unfavorable adjustable-rate mortgage products. With these loans, it may take years before you even start paying down the principal amount that you’ve borrowed, especially if you’re locked into a higher interest rate thanks to the subprime status of the loan.
Are Subprimes Worth It?
There may be a few instances where a subprime loan will work out in your favor, though it’s much less likely than with prime loans. A lot of it depends on your current financial health and how you came to have less-than-perfect credit. Most people with credit problems will be better served by improving their financial status before shopping for a loan, but there may be a few situations where this isn’t the case.
If you have good reason to go ahead with a subprime loan instead of focusing on rebuilding your credit until you can get a much better prime loan, you need to put even more thought and research into the decision than you would otherwise. Shopping around for a loan is always important; given the pitfalls that can occur with subprime lending, it’s essential if you’re trying to borrow against a damaged credit rating.
It’s pretty safe to say that no subprime loan is going to be a good loan product for the long term. Even if you find a quality lender who doesn’t overcharge interest or require unreasonable down payment, you’ll still pay significantly more for your loan than you would if you waited and repaired your credit. If you get roped into an unqualified loan that focuses on paying interest instead of paying down principal, then this payment gap only gets worse.
The only counter to this is to view your subprime loan as a temporary measure; once you have the loan, your next goal should be to refinance it as soon as possible into something with better terms. Make sure that your lender doesn’t saddle you with additional fees for refinancing or early repayment, then do everything you can to improve your financial situation so you can qualify for a better loan. You’ll still likely pay more than you would have by waiting in the first place, but at least this will minimize the over payment.