What it means
Lenders look at credit scores, payment history, existing debts and income to decide how risky a borrower is. A borrower with late payments, defaults, high debt compared with income or a short credit history is placed in a lower tier, often called subprime.
Scoring models differ, but a score below the mid-600s on the common 300 to 850 scale is typically treated as weaker. Subprime is not a single fixed category, and lenders draw the line in different places.
Some separate near-prime borrowers, who are only slightly below the best tier, from deep-subprime borrowers with serious problems. The same person might be treated differently by two lenders depending on the product and the lender's appetite.
The extra cost reflects risk. A lender expects more of these loans to go unpaid, so it charges a higher rate and fees to cover the losses it expects.
This is called risk-based pricing, and it is the reason a subprime borrower can pay several percentage points more than a prime borrower for the same loan. For a small business, owners with weak personal credit may find their company is treated the same way.
A start-up founder who has missed payments may be asked for a personal guarantee, extra collateral or a larger deposit before a lender will agree. Lenders also look beyond the score.
A stable job, a long record at the same address, a larger deposit or a co-signer with strong credit can offset a weak history, and some lenders weigh these factors heavily when the score alone looks poor. Borrowers can move out of subprime.
Paying on time, reducing balances and correcting errors on credit reports gradually lift a score, and a lender may agree to refinance (replace the loan with a cheaper one) once the record improves.
In practice
Real-world examples.
Example
A self-employed designer with two missed credit card payments applies for a car loan. The lender offers the loan at a rate several points above the standard rate and asks for a larger deposit. The designer compares three lenders and chooses the one with the lowest total cost, not the lowest monthly payment.
Example
A small retailer whose owner went through a previous business failure asks for a $100,000 working capital loan. The lender approves it only with a personal guarantee and a higher rate than a business with a clean record would pay.
Example
A young professional with no credit history applies for a first mortgage. The lender treats the thin file as higher risk and asks for a 20% deposit instead of a smaller amount.
Formula
Calculation
The extra first-year interest bill can be estimated with:
Extra interest = Loan amount x (Subprime rate - Prime rate)
Suppose a borrower takes a $200,000 loan at 9.5% because of a weak credit record, while a prime borrower would pay 6.5%. Interest in the first year, before any repayments reduce the balance, is $200,000 x 0.095 = $19,000 for the subprime borrower and $200,000 x 0.065 = $13,000 for the prime borrower. The extra cost is $200,000 x (0.095 - 0.065) = $6,000, which equals the $19,000 - $13,000 difference.Case study
Seen in the real world.
Arjun Patel is an illustrative, fictional borrower with a credit score of 580 after a period of unemployment. He applied for a $15,000 car loan to get to a new job and was quoted a rate of 14%, compared with 7% for a borrower with a good record.
He accepted the loan, set up automatic payments and made every one on time for two years. His score rose above 660 and a different lender agreed to refinance the remaining balance at 9%.
In this illustrative story, Arjun paid more than he would have with a spotless record, but the loan helped him rebuild his credit. The lesson is that a subprime rate is expensive, so the sensible plan is to treat it as a stepping stone and refinance as soon as the lender offers a better deal.
Watch out
Common mistakes.
- Assuming a subprime label means the borrower is irresponsible, when it may reflect a past illness, job loss or a short credit history.
- Accepting the first offer without comparing rates, fees and penalties across lenders.
- Taking the cheapest monthly payment without checking the total cost over the whole term.
Questions
People also ask.
What credit score counts as subprime?
There is no single official line, but lenders commonly treat scores below the mid-600s on the 300 to 850 scale as weaker.
Can a subprime borrower become prime?
Yes, by paying on time, lowering debt and correcting mistakes on credit reports, usually over a period of months or years.
Why do subprime borrowers pay more?
Lenders expect more defaults and charge higher rates and fees to cover the losses they expect.
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