A sub-prime loan generally denotes a loan that has a higher interest rate than a prime rate loan. Sub-prime loans are meant and useful for people with poor or limited credit history. The reason behind attaching a higher interest rate is to cover the high risks involved in lending to prospective sub-prime borrowers.

Not all the lenders present themselves as sub-prime lenders. It is the high rate of interest that differentiates sub-prime lenders from others. If your credit history or ability allows you to have a prime loan, simply avoid sub-prime loans and lenders.

A borrower who has a low credit score and thus fails to qualify to get a prime loan usually becomes a potential sub-prime borrower. The credit score used to ascertain this is also known as a FICO Score. With some additional factors taken into consideration, a person with a mid-range FICO Score qualifies for a sub-prime loan. Factors which are taken into account usually include proposed down payment, ability to document the income quoted and the amount of debt of the applicant. It may so happen that some of the borrowers are unable to document their income like those who are self-employed. These borrowers have an option to apply for stated income loan where they simply (and honestly) state their income on the application form. Due to the fact that these stated incomes are unverifiable, a higher interest rate is charged with the sub-prime loans granted to the borrowers of this category.

The factors which are considered by lenders for approving sub-prime loans to their borrowers are same as those of prime loans. Because of the low down payment and low credit scores, interest rates determined in sub-prime loans are higher. The higher risk and higher costs associated with sub-prime loans make the fees and interest rates rise higher.

When do prime borrowers become sub-prime?

Quite surprisingly, you may find many prime borrowers with good credit scores, required down payment ability and documented income ultimately end up paying for sub-prime loans. The main reason for this is the fact that the borrowers somewhat fall in the trap of the extensive media campaign on the TV or radio by the sub-prime lenders boasting about their attractive deals in financing or refinancing your mortgage. These so called ‘unbelievable deals’ offer you cash that may lower the interest rates and eventually the monthly installments, but what they do not mention is the early expiry of such lower rates and consequent extremely high pay-back of your home’s loan which may amount to almost double.

When you do a market analysis for financing or re-financing your home, check for the pros and cons of the different loan options. Remember, TV is primarily meant for entertainment and NOT draining your wallet. You must always double check your eligibility for a prime loan with leading lenders.

Wall Street Journal made a very interesting report about prime borrowers becoming sub-prime. According to their findings, in 2006 alone, about 61% sub-prime borrowers had a credit score that allowed them to be a prime borrower. The figure says it all!

The reason why sub-prime loans continue to exist is the predominance of the borrowers with no or poor credit conditions. They are considered as ‘riskier’ borrowers by the lenders. This is why sub-prime borrowers should be prepared to encounter surprises like higher payments, higher losses along with the endless supply of various prospects.

- Mohammad Yousuf is a freelance article and web-content writer -

photo credit: @MSG