What it means
Mainstream lenders usually set a minimum credit standard, and applicants below it are turned away. Subprime lenders build their business around those applicants, using their own models, higher pricing and closer monitoring to make the lending pay.
Their income has to cover three costs: funding the money they lend, running the business and the losses from borrowers who do not repay. Because losses are higher, the interest rate must be higher too, which is how a subprime lender can be profitable on a group of loans where a meaningful share goes bad.
The best subprime lenders do more than charge a high rate. They check income carefully, set sensible loan sizes, take security where they can, collect early and keep in touch with borrowers.
Poor ones lend without checking affordability, and that has caused serious harm to borrowers and to the lenders themselves. Subprime lenders face tighter rules in many countries, including limits on rates and fees, disclosure of total cost and requirements to check ability to pay.
They usually rely on borrowing from banks or on selling their loans to investors to fund their operations, so a freeze in those markets can hurt them quickly. Competition and reputation shape the sector.
Lenders that treat borrowers fairly tend to win repeat business and referrals, while those that rely on penalty fees and aggressive collection draw complaints and regulatory attention. A borrower can improve the odds of a good outcome by asking for the full cost in writing and by comparing at least three offers.
For a business owner, a subprime lender can be a source of finance when banks say no. The risk is cost: a short-term loan that looks manageable may be very expensive when stated as an annual rate, so compare the annual percentage rate (the yearly cost including fees) rather than the headline monthly charge.
In practice
Real-world examples.
Example
A used-car dealer's finance arm lends to buyers who were refused by banks. It charges higher rates and fits tracking and payment reminders to the cars to reduce losses. This lets the lender approve more customers while keeping its default rate within the level its pricing was designed for.
Example
An online lender offers small loans of up to $5,000 to gig workers with limited credit history. It uses bank account data and income patterns to decide who qualifies and at what rate. It reviews its results every quarter and adjusts its criteria when defaults rise.
Example
A specialist finance company lends to small firms against their invoices after the owners were turned down for overdrafts. It charges a fee on each invoice and checks the creditworthiness of the customers who will pay them.
Formula
Calculation
A lender sets its required yield by adding its funding cost, expected credit losses and operating costs:
Required yield = Funding cost + Expected loss rate + Operating cost
Expected loss rate = Default rate x Loss given default
A subprime lender has a $10,000,000 loan book. It expects 8% of loans to default and expects to lose 50% of the balance on each default, so the expected loss rate is 0.08 x 0.50 = 4%, or $400,000 a year. With a funding cost of 5% and operating costs of 2%, the required yield is 5% + 4% + 2% = 11%, which on $10,000,000 is $1,100,000 of interest and fees a year.Case study
Seen in the real world.
Greystone Finance is an illustrative, fictional lender that served borrowers with credit scores between 550 and 640. In its first year it made $20,000,000 of loans at an average rate of 16% and funded them with bank borrowing at 6%.
Losses ran at 6% of balances, the cost of operating the business at 3%, and so the lender kept a margin of 1% after all costs. When its bank tightened terms and the funding cost rose by 2%, the margin turned into a loss of 1%.
In this illustrative story, Greystone raised its rates, cut lending to its riskiest group and found a second source of funding. The experience showed that a subprime lender's profit is narrow and depends as much on funding as on borrowers repaying.
Watch out
Common mistakes.
- Assuming all subprime lenders behave the same way, when responsible ones check affordability and others do not.
- Comparing only the monthly payment and not the annual percentage rate and total repayment.
- Forgetting that the lender's funding source can change, which can lead to sudden changes in its terms.
Questions
People also ask.
Is a subprime lender the same as a payday lender?
Not exactly, because subprime lenders offer many products such as car loans, mortgages and cards, while payday lenders focus on very short-term small loans.
Are subprime lenders regulated?
Yes, in most countries lending is regulated, and rules often cover disclosure, fees, affordability and collection practices.
How does a subprime lender make money?
It earns interest and fees that are higher than its funding costs, expected losses and operating costs combined.
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