Subprime lending (also: B-Paper, B-tier, non-prime, near-prime, special finance, second chance lending) describes a specific lending market sector. Typically, subprime customers are those who do not qualify for prime market rates because of a blemished or limited credit history. Subprime customers are therefore charged a higher interest rate, to compensate for the increased future probability of default.
The general lending philosophy can be described as "priced to risk," where the interest rate the borrower pays increases as their risk level to the lender increases. In the United States, subprime borrowers are generally defined as individuals with limited income or a FICO credit score below 620 (on a scale between 300 and 850).
Origins and Motivations
Subprime lending evolved the same way as other businesses, with a realization of the demand in the marketplace and then providing a supply to meet it. With divorce being common in society, bankruptcies and consumer proposals being widely accessible, a constantly fluctuating economic environment, and consumer debt load on the rise, traditional lenders are more cautious and have been turning away a record amount of potential customers.[citation needed] Statistically, approximately 25% of the population falls into this category (credit score < 620).[citation needed]
Motivation for the Lender
To access this increasing market, lenders take on the risks associated with lending to people with poor credit ratings. Subprime loans are considered to be risky for the lender due to borrower's weaker or limited credit history. A weak credit history may include a history of late credit card payments, one or more 30 day mortgage lates, and notices of default. Lenders subsquently adjust their underwriting criteria to reflect the increased payment risk. This payment risk is reflected by charging a higher interest rate over the life of the loan.
Motivation for the Borrower
Subprime lending offers the opportunity for borrowers with less then ideal credit to gain access to credit. Borrowers subsequently use this credit to purchase homes, or in the case of a cash out refinance, finance other forms of spending such as purchasing a car, paying for living expenses, or even paying down a high interest credit card. However due to the risk profile of the subprime borrower, this access to credit comes at the price of higher interest rates.
Subprime Lending and Re-establishing Personal Credit
Some subprime finance companies offer customers with poor credit a chance to re-establish their credit and eventually become a prime customer. Consumers with poor credit can borrow at higher-interest rates from subprime lenders. Once the borrower has shown responsibility in paying off debts and re-established a positive payment history, credit rating can increase. While an overwhelming majority of mortgage loans, subprime or otherwise, are reported to credit bureaus, not all are.[citation needed] Customers wishing to re-establishing their credit should check that their payment history is reported.
Recent Problems with Sub-Prime Lenders
Recently many subprime lenders have gone bankrupt or stop making loans. The prevailing cause for their insolvency or exit from the subprime market is increased defaults from the loans these lenders have originated. The increase in defaults can be artibuted to the type of loans being made by subprime lenders. A common subprime loan product is the "2-28" loan. A "2-28" loan is a loan with a low initial interest rate that is fixed for two years. After two years the interest rate resets to a higher adjustable rate for the remaining life of the loan, in this case 28 years. Other varients of the "2-28" loan product are the "3-27" and the "4-26". One of the concerns with such loan products is that the borrower qualifies for the initial start rate which may be as low 1-2% APR. After say 2 years, when interest rate resets, the borrower may suddenly find themselves unable to make their payments. The new interest is typically some margin over an adjustable index. For example 5% over 12 month LIBOR which would be 10.203% as of 3-19-07. Many of the loans made to subprime borrowers in the recent real estate boom have been of the "2-28" variety. The "2-28" product is designed to have the borrower refinance after 2 years, when the fixed portion of the loan is over. For the borrower refinancing is not problematic provided that their homes have held or increased in value. If the borrower has some equity in their home then depreciating home values are not so troubling. However what happens when the borrower has borrowed 100% of the value of their home and the value of their home decreases? In such a situation the borrower is said to be "underwater": owing more then the home is worth. Borrowers finding themselves unable to refinance out of crushing monthly payments are faced with two options: keep making payments or stop making payments. In the latter case the borrower defaults on their loan resulting in a loss of revenue for the lender.
New Century Financial, previously the second largest sub-prime mortgage lender in the U.S., in March 2007 stopped accepting loan applications was delisted from the NYSE as a result of difficulties with its subprime loans.
The general lending philosophy can be described as "priced to risk," where the interest rate the borrower pays increases as their risk level to the lender increases. In the United States, subprime borrowers are generally defined as individuals with limited income or a FICO credit score below 620 (on a scale between 300 and 850).
Origins and Motivations
Subprime lending evolved the same way as other businesses, with a realization of the demand in the marketplace and then providing a supply to meet it. With divorce being common in society, bankruptcies and consumer proposals being widely accessible, a constantly fluctuating economic environment, and consumer debt load on the rise, traditional lenders are more cautious and have been turning away a record amount of potential customers.[citation needed] Statistically, approximately 25% of the population falls into this category (credit score < 620).[citation needed]
Motivation for the Lender
To access this increasing market, lenders take on the risks associated with lending to people with poor credit ratings. Subprime loans are considered to be risky for the lender due to borrower's weaker or limited credit history. A weak credit history may include a history of late credit card payments, one or more 30 day mortgage lates, and notices of default. Lenders subsquently adjust their underwriting criteria to reflect the increased payment risk. This payment risk is reflected by charging a higher interest rate over the life of the loan.
Motivation for the Borrower
Subprime lending offers the opportunity for borrowers with less then ideal credit to gain access to credit. Borrowers subsequently use this credit to purchase homes, or in the case of a cash out refinance, finance other forms of spending such as purchasing a car, paying for living expenses, or even paying down a high interest credit card. However due to the risk profile of the subprime borrower, this access to credit comes at the price of higher interest rates.
Subprime Lending and Re-establishing Personal Credit
Some subprime finance companies offer customers with poor credit a chance to re-establish their credit and eventually become a prime customer. Consumers with poor credit can borrow at higher-interest rates from subprime lenders. Once the borrower has shown responsibility in paying off debts and re-established a positive payment history, credit rating can increase. While an overwhelming majority of mortgage loans, subprime or otherwise, are reported to credit bureaus, not all are.[citation needed] Customers wishing to re-establishing their credit should check that their payment history is reported.
Recent Problems with Sub-Prime Lenders
Recently many subprime lenders have gone bankrupt or stop making loans. The prevailing cause for their insolvency or exit from the subprime market is increased defaults from the loans these lenders have originated. The increase in defaults can be artibuted to the type of loans being made by subprime lenders. A common subprime loan product is the "2-28" loan. A "2-28" loan is a loan with a low initial interest rate that is fixed for two years. After two years the interest rate resets to a higher adjustable rate for the remaining life of the loan, in this case 28 years. Other varients of the "2-28" loan product are the "3-27" and the "4-26". One of the concerns with such loan products is that the borrower qualifies for the initial start rate which may be as low 1-2% APR. After say 2 years, when interest rate resets, the borrower may suddenly find themselves unable to make their payments. The new interest is typically some margin over an adjustable index. For example 5% over 12 month LIBOR which would be 10.203% as of 3-19-07. Many of the loans made to subprime borrowers in the recent real estate boom have been of the "2-28" variety. The "2-28" product is designed to have the borrower refinance after 2 years, when the fixed portion of the loan is over. For the borrower refinancing is not problematic provided that their homes have held or increased in value. If the borrower has some equity in their home then depreciating home values are not so troubling. However what happens when the borrower has borrowed 100% of the value of their home and the value of their home decreases? In such a situation the borrower is said to be "underwater": owing more then the home is worth. Borrowers finding themselves unable to refinance out of crushing monthly payments are faced with two options: keep making payments or stop making payments. In the latter case the borrower defaults on their loan resulting in a loss of revenue for the lender.
New Century Financial, previously the second largest sub-prime mortgage lender in the U.S., in March 2007 stopped accepting loan applications was delisted from the NYSE as a result of difficulties with its subprime loans.
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