Subprime: Meaning, Global Financial Crisis, Example

What Does Subprime Mean?

Subprime is a credit classification for borrowers with a tarnished or limited credit history and for loans made to such borrowers. Because subprime borrowers are considered riskier than the average borrower, subprime loans are subject to higher than average interest rates.

What Is a Subprime Borrower?

Borrowers can be classified as subprime for a number of reasons. Often it is because they have had trouble paying their bills in the past, as reflected in their credit reports and credit scores. It may also be that they simply haven't had enough credit accounts yet to establish a track record, as can be the case with new graduates or recently arrived immigrants. This is sometimes referred to as having a thin file.

Occasionally, borrowers will be classified as subprime despite having a good credit history. In those cases it is typically because they failed to provide sufficient verification of their income or assets in the loan application process.

What Is a Subprime Loan?

Subprime loans come in a variety of types. Stated income and stated asset (SISA) loans and no income, no asset (NINA) loans, for example, are loans where the lender doesn't verify all of the information the applicant supplies but essentially takes their word for it.

In mortgage lending, subprime borrowers present relatively less risk than with other types of loans because the home typically serves as collateral and the lender can foreclose on it and sell it if necessary to recoup at least a portion of the debt. Still, subprime borrowers may have a more difficult time obtaining a mortgage and can expect to pay a higher interest rate than the average borrower if they do.

A variety of fintech companies, including online lenders, now focus on the subprime market, particularly thin-file borrowers. Credit rating agencies have also developed new credit scoring methodologies for such borrowers. For example, the VantageScore 4.0 model will assign a score to borrowers with a credit history shorter than the six months required by most other scoring models. That has helped to increase the available offerings for some subprime borrowers.

One widely available product that provides an alternative for subprime borrowers is the secured credit card. Unlike regular credit cards, secured cards require the borrower to deposit a sum of money into a special bank account, which then becomes a credit line that they can borrow against. After making on-time payments for a certain number of months, the borrower may be eligible to upgrade to a regular credit card with a higher credit limit. Those consistent payments will help boost their credit score, as well.

Some issuers also offer unsecured credit cards for subprime borrowers. For example, Credit One Bank has several cards for borrowers whose credit scores are only in the "fair" range. Its Platinum Mastercard charges no annual fee, while its QuickSilver One card has a $39 annual fee but also pays 1.5% cash back on purchases.

Unsecured subprime credit cards tend to have relatively high interest rates (a 29.99% APR in the case of those Capital One Cards), so they can be costly for anyone who doesn't pay their bill in full each month.

Other second chance loans available to subprime borrowers include subprime auto loans and subprime personal loans, all with commensurately high interest rates. Another alternative is the short-term payday loan, which most consumer advocates scorn and which can carry interest rates approaching 400% in some states.

Subprime Loans and the Global Financial Crisis

Subprime loans played a major role in the global financial crisis that began in 2007. Many of the subprime mortgages that were issued in the years leading up to the crisis carried adjustable interest rates. For the first several years, the borrower's interest rate and monthly payments remained relatively low. But after three to five years, the interest rate adjusted upward and made the monthly mortgage payments unaffordable for many borrowers. In the meantime, many homes had also lost value, making it impossible for their owners to refinance their mortgages.

Before the crisis hit, subprime loans were often pooled together, packaged as mortgage-backed securities, and sold to investors. The theory was that even if some borrowers defaulted on their loans, most would continue to make their payments, so the investors' money was relatively safe. However, when unexpectedly large numbers of borrowers defaulted, that all fell apart.

In the wake of the crisis, the Dodd-Frank Act in the U.S. and other reforms elsewhere in the world imposed new regulations to rein in some of the risky lending practices that had been largely responsible for it.

The Bottom Line

Subprime borrowers can have difficulty obtaining credit, and if they can, it will usually come with significantly higher interest rates. Fortunately, subprime borrowers can improve their credit over time and move up into prime territory.