What it means
Lenders start with a benchmark, such as the prime rate or a central bank rate, and then add a margin for the risk of the individual borrower. A borrower with an excellent record might pay the benchmark plus a small margin, while a subprime borrower pays the benchmark plus a much larger one.
The margin has to cover several things: the extra losses the lender expects from borrowers who fail to repay, the extra cost of collecting late payments, and a return for taking on more risk. It is reasonable for a risky loan to cost more, but the gap should be explained and not simply assumed.
Subprime rates can be fixed or variable. A variable rate moves up and down with the benchmark, so a rise in market rates can make payments climb without any change in the borrower's behaviour.
Lenders also change rates over time. After a borrower has made twelve or twenty-four on-time payments, some lenders will offer a lower rate, and others will do so only if the borrower asks.
A short call to the lender, with a record of payments to hand, can save a surprising amount. The annual percentage rate (APR) gives the best comparison because it includes fees as well as interest.
A loan with a modest headline rate and large upfront fees can cost as much as one with a higher headline rate and no fees. Many countries set limits, called usury caps, on the maximum rate a lender may charge, and the rules differ from place to place.
A borrower should compare offers, ask what rate they would qualify for after twelve months of on-time payments, and avoid loans with steep penalties for repaying early.
In practice
Real-world examples.
Example
A shop owner with a past late payment applies for a $25,000 equipment loan. The lender offers the loan at the benchmark plus 4%, while a competitor with a spotless record is offered the benchmark plus 1%. Over a five-year loan, the difference in cost is large enough to matter to the owner's budget.
Example
A graduate with a thin credit file is offered a credit card with a rate several points above the average. She pays the balance in full each month to avoid interest and slowly builds a credit record. After a year, she receives a higher limit and a better offer from the same lender.
Example
A construction firm that has had cash flow problems is quoted a higher rate on a bridging loan. The finance director negotiates a lower rate by offering extra security over a piece of machinery. The lender agrees because the machinery would cover most of the loan if the firm failed to repay.
Formula
Calculation
A subprime rate is built up from a benchmark and a risk margin:
Borrower rate = Benchmark rate + Risk margin
Suppose the benchmark is 7.5% and a lender adds a risk margin of 4% for a borrower with a weak record. The borrower rate is 7.5% + 4% = 11.5%. On a $25,000 balance, the first year's interest is $25,000 x 0.115 = $2,875, compared with $25,000 x 0.075 = $1,875 at the benchmark alone, so the risk margin costs $1,000 a year. Over three years with no repayments, that is $3,000 of extra interest, which is why even small differences in margin deserve attention.Case study
Seen in the real world.
Pinewood Catering is an illustrative, fictional company that needed a $50,000 loan for a new van and kitchen equipment. Because of late payments the year before, the best offer it received was a rate of 13%, compared with 8% for a business with a clean record.
The owner calculated that the extra 5% would cost $2,500 in the first year, and she asked her accountant whether the project still made sense. The new equipment was expected to add $20,000 of profit a year, so the project cleared the hurdle even with the higher rate. She also set aside a small cash reserve in case a slow month made the payment hard to meet.
In this illustrative story, she took the loan, paid on time for eighteen months and then asked the lender to review her rate. The lender cut it to 10%, and she later refinanced the rest with a bank at 8%.
Watch out
Common mistakes.
- Comparing only the headline rate and ignoring fees, which the annual percentage rate captures.
- Assuming a high rate is permanent, when many lenders will reprice after a record of on-time payments.
- Choosing a variable rate without testing what happens to the payment if market rates rise.
Questions
People also ask.
Why are subprime rates higher?
The lender expects more losses and charges extra interest to cover them, along with the higher cost of chasing late payments and the return it wants for taking the added risk.
Is there a limit on subprime rates?
Many places set a legal maximum, but the limit and how it applies differ by country, product and lender.
How can I get a lower rate?
You can improve your credit record, offer security, add a creditworthy co-signer or borrow a smaller amount, and it also helps to compare several lenders so that each knows it is competing.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%Related