What it means
When a lender decides a borrower falls below its standard credit tier, it can decline the application or offer a loan priced for the extra risk. The second route is the subprime loan, and it exists in nearly every kind of lending.
These loans differ from standard ones in cost and in terms. Rates are higher, fees may be larger, deposits may be bigger and some loans carry penalties for early repayment.
Adjustable-rate versions, where the rate can rise later, can become hard to afford if the borrower's income does not grow. The danger is the total cost.
A low payment today can hide a high rate, a long term or charges that build up, so what matters is the annual percentage rate and the full amount repaid. Some lenders quote an add-on rate, which is calculated on the original amount for the whole term, and it is considerably costlier than it appears.
A subprime loan can be useful when it is affordable and used to rebuild a credit record. Steady on-time payments are reported to credit agencies and gradually lift the borrower's score, which opens the door to refinancing at a lower rate.
Secured and unsecured versions behave differently. A secured subprime loan, such as a car loan, lets the lender repossess the asset if payments stop, which lowers its risk but means the borrower can lose something essential.
An unsecured loan relies on the borrower's promise alone and usually carries an even higher rate. For businesses, the same ideas apply to loans taken by owners or companies with weak credit.
Before signing, test whether cash flow can cover the payments even in a weak month, and check whether the loan allows early repayment without a penalty.
In practice
Real-world examples.
Example
A shop assistant with a low credit score buys a used car with a subprime loan. The monthly payment is manageable, but the interest charge across the full term adds up to a large share of the price of the car. She decides to repay extra when she can, after confirming there is no early repayment penalty.
Example
A small restaurant owner with past late payments takes a $60,000 business loan at a high rate to buy kitchen equipment. She plans to refinance after 18 months of on-time payments.
Example
A couple with a short credit history are offered a mortgage whose rate is fixed for two years and then adjusts upward. They calculate the higher payment before they sign to make sure they could afford it.
Formula
Calculation
An add-on loan charges interest on the original amount for the full term:
Total interest = Loan x Rate x Years
Total repayment = Loan + Total interest
Monthly payment = Total repayment / Number of months
Take an $18,000 loan at a 20% add-on rate over 3 years. Interest is $18,000 x 0.20 x 3 = $10,800, the total repayment is $18,000 + $10,800 = $28,800 and the monthly payment is $28,800 / 36 = $800. For comparison, the same loan at a 6% add-on rate costs $18,000 x 0.06 x 3 = $3,240 in interest, so the weaker credit record costs an extra $7,560 over the term.Case study
Seen in the real world.
Lakeside Bakery is an illustrative, fictional business that needed $40,000 for a new oven after the owner had two years of late supplier payments. Banks declined the request, but a specialist lender offered the money at 18% for four years.
The owner first built a cash flow forecast and found that the monthly cost, about $1,200 a month in payments, was covered by additional bread sales from the larger oven. She signed, added a reminder system for supplier bills and made every payment on time.
After two years in this illustrative story, her record had improved, and a high-street bank agreed to refinance the remaining balance at 10%. The subprime loan had been expensive, but it paid for itself through new sales and led to cheaper finance.
Watch out
Common mistakes.
- Focusing on the monthly payment and ignoring the total interest paid over the term.
- Not reading the terms on early repayment, rate resets and late fees.
- Borrowing the largest amount offered rather than the smallest amount the project needs.
Questions
People also ask.
How is a subprime loan different from a normal loan?
The product can look the same, but the interest rate, fees and conditions are set higher because the borrower is seen as riskier.
Can I repay a subprime loan early?
Many allow it, but some charge a penalty, so check the contract before signing.
Will a subprime loan improve my credit?
It can if the lender reports to credit agencies and every payment is made on time.
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