Subprime lending

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Subprime lending (also: B-Paper, B-tier, non-prime, near-prime, special finance, second chance lending) describes loans to customers having a credit score below 620[1], although there is no official definition -- others consider subprime loans to borrowers with credit scores below 650 or 660, for example.

Typically, subprime customers are those who do not qualify for prime market rates because of a low credit score. Subprime loans are considered more risky, and generally have a higher rate of default than prime borrowers. Subprime lending programs were created for borrowers unable to qualify for loans under traditional, more stringent criteria. Subprime borrowers tend to pay more for the loans to compensate for the increased probability of future default. This charge may come in the form of a higher interest rate, regularly charged fees, or an up-front fee.

According to the 2001 Expanded Guidance for Subprime Lending Programs, a subprime loan refers to "... the credit characteristics of individual borrowers. Subprime borrowers typically have weakened credit histories that include payment delinquencies, and possibly more severe problems such as charge-offs, judgments, and bankruptcies. They may also display reduced repayment capacity as measured by credit scores, debt-to-income ratios, or other criteria that may encompass borrowers with incomplete credit histories. Subprime loans are loans to borrowers displaying one or more of these characteristics at the time of origination or purchase. Such loans have a higher risk of default than loans to prime borrowers."

Contents

[edit] Characteristics of subprime borrowers

Generally, subprime borrowers will display a range of credit risk characteristics that may include one or more of the following:

  • Two or more loan payment paid past 30 days due in the last 12 months, or one or more loan payments paid past 60 days due the last 24 months;
  • Judgment, foreclosure, repossession, or non-payment of a loan in the prior 24 months;
  • Bankruptcy in the last 5 years;
  • Relatively high default probability as evidenced by, for example, a credit bureau risk score (FICO) of 660 or below (depending on the product/collateral), or other bureau or proprietary scores with an equivalent default probability likelihood; and/or
  • Ratio of debt owed to income of 50% or greater, or otherwise limited ability to cover family living expenses after deducting total monthly debt-service requirements from monthly income.
  • Non-traditional proof of income including cash-flow based on bank statements or not providing any documentation of income or assets.

[edit] Origins and Motivations

Subprime lending evolved with the realization of a demand in the marketplace and businesses providing a supply to meet it. With 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 number of potential customers.[citation needed] Statistically, approximately 25% of the population falls into this category (credit score < 620).[citation needed]

[edit] 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 carry greater risk for the lender due to earlier mentioned credit risk characteristics of the typical Subprime borrower. Lenders use a variety of methods to offset these risks. In the case of many Subprime loans, this risk is offset with a higher interest rates. In the case of Subprime credit cards, a Subprime customer may be charged higher late fees, higher over limit fees, yearly fees, or up front fees for the card. In the case of Subprime credit cards, in contrast to Prime credit cards, customers generally are not given a "grace period" to pay late. These late fees are then charged to the account, which frequently drive the customer over their limit, resulting in over limit fees. Thus the fees compound, resulting in higher returns for the lenders.

[edit] Motivation for the Borrower

Subprime offers the opportunity for borrowers with less than ideal credit to gain access to credit. Borrowers 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, remodeling a home, 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.

[edit] 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.

[edit] Recent Problems with Sub-Prime Lenders

Recently many subprime lenders have gone bankrupt or stopped making loans. The prevailing cause for their insolvency or exit from the subprime market has been the fact that investment banks or other providers of warehouse lines of credit have cancelled these lines, due to, among other factors, increased defaults found in the loans these lenders have originated, as well as early payment defaults (EPDs) which are missed payments early in the life of a loan. Contracts generally require that a broker buy back a loan from a secondary market purchaser that experiences a missed payment within the first 3-6 months of the loan - an EPD.

The increase in defaults has often been attributed to a combination of falling housing prices and the type of loans being made by subprime lenders. A common subprime loan product is the "2-28" loan. A "2-28" loan is one with a low initial interest rate that stays 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. Variations on the "2-28" loan concept include the "3-27" and the "5-25". One of the concerns with such loan products is that if the borrower is qualified for the initial start rate (which may be as low 1-2% APR), as opposed to the fully indexed rate, the lender has not have taken into account the borrower's ability to repay the loan. This practice mainly can been seen as a result of a long period of rising house prices, as in the last 10 or so years it did not matter if the borrower could actually repay the loan; the borrower could simply sell the house, make a profit, and pay off the loan. With an hybrid ARM (adjustable rate mortgage), such as a 2-28, the interest rate will reset at the end of the fixed period and the borrower may be unable to make his payments. This is often referred to as "payment shock". The new interest rate is typically set at some margin over an index, for example, 5% over 12-month LIBOR, which would amount to 10.203% as of 19 March 2007. Interest only loans, where the borrower only pays interest payments for a period of time (typically 5 or 10 years), and pay option ARMs, where the borrower has a choice of payments (full payment, interest only, or a minimum payment which may be lower than the payment required to reduce the balance of the loan - ie a payment amount that causes an increase to the amount owed, or "negative amortization") are generally sold to borrowers with higher credit scores - generally Alt-A or prime borrowers - because of the increased risk characteristics of these loans.

In the case of Subprime credit card lenders, the minimum payment is the amount the lender requires the customer to pay on any outstanding balance every month. In the past, many Subprime lenders would charge minimum payments such that the payment would not be enough to pay down the result of the interest rate on the balance. Thus, if a customer only paid the minimum payment, they would never pay off the loan. Most lenders are now required to charge minimum payments such that customers who pay minimum payments will amortize the loan balance.

[edit] Subprime Credit Card Lenders

Some Subprime credit card companies include Capital One, Harvest Bank and Orchard Bank.

[edit] Sources

[edit] External links

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