Subprime
From Wikipedia, the free encyclopedia
Subprime (also sub-prime, 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 blemished or limited credit. Consequently, subprime customers are charged a higher interest rate to compensate for the increased risk. The general lending philosophy can be described as "priced to risk"; the higher the risk on the deal, the higher the interest rate. (Each country has a legal maximum annual interest rate).
Subprime lending evolved the same way as any other business. Visionaries recognized the demand in the marketplace and have gained success from providing a supply. With the divorce rate hovering at 50%, bankruptcies and consumer proposals available to anyone who can make a case, a fluctuating economy, and consumer debt load on the rise, traditional lenders are turning away a record amount of potential customers. Statistically, approximately 25% of the population falls into this category (credit score < 700).
Subprime Companies are usually stand-alone and are not affiliated with Prime lenders (who take little risk with their funds). However as subprime companies develop, gain market share, go public, pay strong dividends, and earn aggressive returns, the traditional lenders are taking notice. For a prime lender, the safest entry into the subprime arena is to acquire an existing subprime company with established brand recognition, time tested policy & procedure, and knowledgeable staff. Examples of this in Canada are TD's acquisition of VFC, Wells Fargo purchasing Trans Canada Credit, and HSBC buying out HFC. The industry is extremely lucrative as long as the company has a very good idea which deals are worthy of their investment. For example, an Applicant who has a credit history that shows a long history of write-off's and slow payments is not a smart risk. On the other hand, an Applicant who has decent credit leading up to an isolated period of poor credit is a smart risk. The first situation can be attributed to negligent behaviour (which will most likely not change), the second to circumstance (divorce, loss of job, sickness, etc) that can be resolved.
Because the applicant's credit is risky, subprime companies often look for added security in the form of collateral. Examples of this are mortgages, vehicle loans, furniture loans, credit cards secured by an initial deposit that matches their credit limit, etc. Once the company registers a lien against the asset(s), the company can repossess the asset(s) and reclaim a portion or all of their loss should the customer default on the loan. (Note that repossession is often a last resort. They would prefer the customer continue to make their payments so they can collect interest on the loan, offer them other products, and continue to refinance them.)
Although far from altruistic, subprime finance companies offer customers a chance to re-establish their credit and eventually become a prime customer. A good analogy is the insurance industry. If a driver has too many infractions and/or accidents, they have to pay a higher premium. If they pay the higher premium and maintain a clean driving record, their insurance will go back down. It is the same with financing. A credit crash requires a few years of paying higher interest rates to re-establish a positive credit rating. If you are a subprime customer seeking financing, make sure and ask if your loan will be reported to the credit bureau companies. If it does not report, other companies will not be able to see your payment history and it will not help re-establish your credit with any lender other than the company you are borrowing from. (The exception is a mortgage as the vast majority of companies do not report mortgages to credit bureaus.)
