Two major categories of loans, prime and subprime, are available for consumers seeking to buy a home or car or to open a new credit card. Subprime loans are designed for those with blemished or non-existing credit histories, and they offer less favorable terms for borrowers than prime loans. Because they carry more risk to lenders, subprime loans typically cost the borrower more.
Subprime lending, particularly in the housing market, was a major factor contributing to home foreclosures and the overall economic crash of 2008. Despite all the problems associated with subprime loans, however, they are making a comeback in housing, auto, personal loan and credit card markets. For example, Experian reported an increase in subprime auto loans -- that is, for consumers with credit scores in the 550-619 range -- during the third quarter of 2012.
Subprime loans come with a higher interest rate designed to compensate the lender for the risk. The difference between a $16,000 auto loan for a prime rate of 4.125 percent for 60 months and the same loan at a subprime rate of 9.7 percent is $34 a month, or about $2,000 over the life of the loan.
Subprime loans also have additional costs. Subprime credit cards often have high annual, up front, late or over-limit fees. Subprime mortgages, while allowing those with low credit scores to buy homes, may require the borrower to pay off the mortgage after three to seven years in a balloon payment. Unless borrowers know that they will have sold the home by then, or feel confident that they can make such a payment, such a loan might not be the best option for them.
Pros and Cons
On the plus side, subprime loans allow those who otherwise wouldn't qualify to buy homes and cars. On the other hand, many pro-consumer organizations, like the Central Florida Education Federal Credit Union, advise consumers to weigh carefully the pros and cons and to consider waiting until they've rebuilt their credit to buy the car or home. When shopping for loans, beware of being offered a subprime loan unnecessarily. If you do your homework beforehand and know what you qualify for -- and if you know what rates you most likely qualify for -- you'll be in a better position to notice if the numbers seem off.
- HUD.gov-U.S. Department of Housing and Urban Development: Subprime Lending
- Responsible Lending - Tools and Resources:Third of Student Loan Debt Belongs to Subprime Borrowers
- Langley Federal Credit Union: How Much Will My Auto Payments Be Calculator
- The Christian Science Monitor: Subprime Loans Are Hot Again -Unfortunately
- Bankrate.com: Shopping for a Subprime Loan
- eFinance Directory:The Pros and Cons of Sub-Prime Lending
- Experian: Auto Financing, Leasing Continue to Rise
- AOL Real Estate: The New Subprime' Mortgage: Risky Loans Emerge in Twist on Seller Financing
- Central Florida Education Federal Credit Union: Prime Loan vs. Subprime Loan from Finance Company Chart
- Stockbyte/Stockbyte/Getty Images