Subprime Loans: The Pros and Cons

A subprime loan is money given by a bank or other lender to a borrower who has less than perfect credit.  The subprime loan market makes money available to people who otherwise could not obtain a loan.  Although advantageous for those who are excluded from other markets, subprime loans carry some significant disadvantages.

Pro:  Ease of Approval

Not all people who need loans have the credit scores necessary to obtain those loans.  Usually, banks or other lenders turn down borrowers who have defaulted on loans in the past or have outstanding debt on their balance sheets.  In the subprime loan market, borrowers who cannot receive loans elsewhere can obtain money.  Credit scores do not need to be perfect for a borrower to be approved.

Pro:  Usefulness

Subprime loans are perfect for people who need to pay off other debts.  Outstanding debts harm a borrower's credit score.  With a low credit score, a borrower can receive a subprime loan, pay off his or her existing debt, and then work to make payments on the subprime loan on time.  As a result of a subprime loan, a borrower can fix his or her credit score    

Con:  Higher Costs

Borrowers that are functioning in the subprime loan market are higher risk than those that are working in the prime loan market.  Borrowers in the subprime market are more likely to default on their loans and therefore pose a higher risk to lending companies or banks.  Interest rates are reflections of risk.  The borrowers in the subprime market have high risks and therefore these loans carry higher interest rates.  The high interest rate compensates the bank or lending company in case the borrower defaults.  This higher interest rate is called subprime where prime is the going rate in the standard market.

Also, the processing fees and other fees associated with obtaining a loan are higher in the subprime loan market.  The bank or lending company needs to collect more money from the borrower up front in order to prepare for default.

Con: Income Demands

Although subprime loan lenders are not as demanding about credit scores as other lenders, they are strict when they examine a borrower's income.  The borrower must have sufficient income and cash flow to cover the contracted monthly payments.  The lending company or bank will make sure, most likely through a check of relevant financial documents, the borrower can meet the payments schedule that he or she chooses.  If a borrower cannot prove that he or she has adequate cash flow, he or she will most likely be turned down.

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