In finance, subprime lending (also
referred to as near-prime, non-prime, and second-chance lending) means making
loans to people who may have difficulty maintaining the repayment schedule,
sometimes reflecting setbacks, such as unemployment, divorce, medical emergencies,
etc.” Wikipedia.
The way a bank figures
out your likelihood to payback a loan is based on the following: How have you
paid other similar accounts? Do you make enough to afford your payment? Are you
financially stable?
In normal lending a bank
or lender is able to calculate and minimize the risk of non-payment. A potential
loan customer has a credit score indicative of paying other accounts. A
customer has income that can be verified and assets. A customer earns enough to present a comfortable payment to income ratio. People
that have these characters can have their choice of loan at competitive rates.
For those that do not
meet requirements in those categories, lenders have created a solution…
Sub-prime. Sub-prime simply means “less than prime.” Traditionally sub-prime
loans are for borrowers having FICO scores below 640. This score range differs
incrementally from lender to lender but if your credit score is below 640 you
are generally a sub-prime borrower.
Sub-prime loans are not in and of themselves bad. While
financial experts warn about hidden fees, undisclosed costs, exorbitant
interest rates and consumers that are quick to take the first offer they
receive instead of shopping around, sub-prime loans do fill a need in lending.
Most of the pitfalls experts warn about are less about sub-prime lending specifically and more about “predatory lending” since all of the major detractions could happen to anyone in
any credit range with a deceptive lender.
It’s always important to
educate yourself when considering a loan, especially for larger amounts like in
car loans and mortgages. While it’s not always easy to read the phone book of
loan documents, you can ask your lender direct questions about fees and terms
until you are satisfied. It’s also necessary to educate yourself about
borrowing in general so you know what general practices are. If you don’t know
what’s normal how could you possible spot an abnormality?
Sub-prime lending serves
a need. Many people wouldn’t be able to have the security of a vehicle or
mortgage without it. It is a legitimate part of the industry that allows
otherwise unqualified consumers to secure car loans and mortgages with a little
more documentation of financial status and likely a higher interest rate.
Many times consumers are
not irresponsible in general. Everyone wants
to pay their bills. People don’t want to go into bankruptcy or foreclosure or
have their car repossessed. Most times, a perfectly well intended consumer
secures a loan at a time when paying that loan is perfectly feasible. Then
tragedy strikes. An expensive break down, job loss, illness or financial
catastrophe knocks them off the peg. One unpaid bill becomes another and a
downward spiral begins. If you can’t get credit after credit problems arise,
how do you prove to lenders that you are now back on your feet and stable
enough to repay a loan? It’s a Catch 22 and sub-prime lending is sometimes the
only answer.
Sub-prime loans usually
entail more documentation or proof that you have the ability to pay. Instead of using
your credit score as an indicator of likely repayment, lenders will use your
“stability and ability.” Are you able to pay (based off of your income and loan
amount), how long have you been able to pay and how long can a lender predict
that you will be able to continue to pay? It will also cost more. A consumer
with a good credit score can expect to have their choice of loan structure and
rates below 6%. This is reflective of the lender's risk in taking the loan. Good
credit customers are more likely to pay and therefore present less risk. Bad
credit customers are less likely to pay and present more risk which is why they
can expect interest rates in excess of 10%.
Bad credit car loans are an area where a consumer can make a
significant improvement in their credit in a short period of time. While car
loans are generally a significant amount, they are still much less and much
shorter than mortgages. It presents an opportunity for consumers to prove again
that they can pay a specified amount each month for an extended period of time.
Since lenders require proof of income and residence, it is likely verified that
you have enough disposable income to repay the loan.
While the sub-prime lending
market can be wrought with problems for lenders and consumers, it gives an
educated consumer coming off financial problems to improve their situation and
get to work while doing it.
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