What are Subprime Loans?

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What are sub-prime loans?


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Subprime has sort of a dual definition.

The first definition is “ non-prime.” This means that it is any loan that is not a prime loan. A prime loan would generally be considered to conform to Fannie Mae or Freddie Mac guidelines. All that really means that prime loans generally have some sort of equity or down payment, or a good debt to income ratio, or strong assets, or a strong credit score. Prime loans DO NOT have to have all 4 of those factors! They simply have to have a “good enough” combination of them to pass through an automated underwriting system.

The loans that don’t pass have to go into other programs which are non-prime. Usually this means higher interest rates or fees, possible prepayment penalties, and various other different features depending on the lender.

Non-prime, however, is not an exact equal of sub-prime. There is the middle ground of “ Alt-A.” Alt-A is a non-prime loan, but is usually offered by a lender that does prime loans. This area of the market is almost completely gone, but it does still exist.

A true sub-prime loan is one that is offered by an actual sub-prime lender. These lenders are in even scarcer supply than Alt-A lenders. Subprime lenders have specialized exclusively in providing loans for people that could not get loans on Prime or Alt-A programs. They are riskier loans, with broader guidelines. For instance, some subprime companies will allow a client to qualify their income using 12 months of bank statements which is something that does not occur with Prime or Alt-A loans. The higher the risk, the worse the terms for the borrowers (in general).

There are some subprime companies that actually compete well against prime loans on certain types of scenarios. Subprime doesn’t always mean someone has a low credit score either. There are a number of reasons someone might not qualify for a prime loan yet still be a strong borrower. Finally, for some of those people with high credit scores, some subprime lenders periodically offer even better programs than prime lenders. It all depends on what the current appetite is among their investors.

So subprime can be defined as non-prime, but an even purer definition is a loan that is originated by a lender dealing exclusively in non-prime loans, with some more forgiving guidelines offset by higher rates or other compensating factors for the investor.

Answered over 6 years ago
Matthew Graham
986 6

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