What are Subprime Loans and Who Qualifies?

Subprime loans are loans that are made to borrowers with blemished credit. Individuals with low credit scores, as measured by the Fair Issacs Corporation, or FICO, can use sub-prime loans for their needs. A subprime loan carries an interest rate that is well above the prime lending rate offered to borrowers with good credit scores.

History of Subprime Loans

Subprime loans began sometime around 1993 as a way to increase lending opportunities to individuals with bad credit. A subprime loan offered a way for lenders during that time to extend a hand out to borrowers that were unable to purchase a home with traditional conventional requirements. The loans were meant to assist borrowers that were technically able to pay for a loan, but, because of other circumstances (like credit) were unable to purchase.

 Hybrid Subprime Loans

Hybrid loans were loans that were fixed for certain amount of time, and then the loans were changed to adjustable loans. The most popular loan types were interest-only loans, 2/28 and 3/27 loans. The 2/28 loan, for example, had a fixed rate for 2 years, and the remaining 28 years of the loan were adjustable rates.

Additionally, interest-only loans were a benefit to borrowers because they only paid the interest on their loans for a period of 5 or 10 years. At the end of the 5 or 10 year cycle, the loan would be recalculated into a fully amortized loan. The remaining loan term typically resulted in larger monthly payments for the remaining term of the loan.

The problem with hybrid loans is that if the borrowers were unable to refinance the loan, prior to the end of the interest-only period or after the fixed term, they were subject to a much higher monthly payment.

Fixed Rate Subprime Loans

Fixed rates were also offered for subprime borrowers. Fixed rates loans had significantly higher rates, typically 2-4 percent higher. The payments were often incredibly higher which made adjustable rates more and more attractive to borrowers.

In addition, the hybrid and interest only products gained popularity because rates were low for ARM loans and because sales prices were high. Many people could not qualify for a home loan without taking out a special financing loan.