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What are Subprime Loans?
What is a Subprime Loan?
This term appears to have been coined only recently and was used a great deal by the media during the height of the financial crisis last year. There is much confusion as to what it actually means? Does it mean a bogus or 'doggey deal'? Does it mean the lender has acted unscrupulously? Does it mean there's something wrong with the borrower?
There is no set definition of the term. However, generally subprime loans is meant to imply that the interest rate is less than the prime rate or the best or usual rate for a loan of that type. As an example, if you apply for a home loan known as a 'full doc loan', and if you qualify then you would expect to get the going rate. If the going rate is around 7% at the time you apply, then your interest rate should be very close to that. However, if you have a poor credit record then the bank will charge you a higher interest rate, perhaps two to five percent more. Alternatively, or as well, it may lower the total amount it is prepared to lend you. The higher interest rate means you have obtained a rate that is less than the 'prime' rate.
In Australia there have been a number of companies that were willing to provide what are called 'non-conforming loans'. Some people might now call these subprime loans. In any event, these are loans where the borrower may have one or more defaults on loans that are still outstanding or that occurred during the past 2 years. Most banks would not lend to these people although a few select lending institutions would. In fact some specialized in these types of loans. In all these cases, because the risk is higher the lender would charge a higher interest rate. Notwithstanding that, the lender would still insist that the borrower be able to meet their criteria for making the repayments.
Some times people get themselves into unfortunate credit situations for reasons that are beyond their control. Take, for example, the family that is suddenly hit with news that a loved one is seriously ill and requires expensive medical treatment. They may quickly find themselves unable to meet their financial obligations in which case defaults will be recorded against their credit history. Down the track they may need to refinance or face a foreclosure by the bank. A non-conforming or subprime loan may be the answer for them and they have proved to be a good product for people in these situations, provided that conservative criteria are used to assess their suitability and ability to meet the repayments.
In the United States, however, there were many types of loans not seen in Australia. We have been accustomed to the 'honeymoon rate'. This means that the borrower gets a rate that is between 1-2% lower than the current variable rate. This could last from between six months to one year. After that period the loan reverts back to the standard variable rate. However, in the United States there were cases where the so-called 'honeymoon period' was extended to several years. At the end of that period, instead of the rate reverting back to the standard variable rate it went much higher, perhaps as much as four to five percentage points above the standard variable rate. This caused great distress for borrowers and caused many to default on their loans.
Cash Loans – are they for you?
In most cases cash loans are those where you borrow funds without providing any security. Usually we refer to cash loans as personal loans. The sum that you can borrow on cash loans is considerably less than for loans where you provide the lender with security. Generally the amount you can borrow on cash loans is limited to somewhere around $25,000 to $30,000. These loans are often used for debt consolidation. For example, if you owe quite a lot of money on credit cards it could be worthwhile consolidating that into a cash loan. There are two main reasons for this. One is that the rate of interest on cash loans, whilst higher than a secured loan, is much lower than that on credit cards. The second reason is that you consolidate all the repayment dates into one date and this is easier to track.
Mortgage Lenders – The Facts
Today, following on from the financial crisis and the thousands of defaults on subprime loans mortgage lenders are much more cautious about lending money. It is not easy to borrow money where you have a record of default and the maximum amount the mortgage lenders are willing to give you is generally less in all cases, i.e. for full doc. or low doc. loans. The no doc. loans that existed before the financial crisis appear to have disappeared altogether. This is probably a good thing. No doubt, down the track when economies are booming again, we will see a loosening of the criteria for lending by the banks but at the current time they are nervous and displaying much greater conservatism.
