Subprime Loan
A loan extended to borrowers with poor credit histories, carrying higher rates to compensate for elevated default risk.
What is Subprime Loan?
A subprime loan is a credit product extended to borrowers who do not qualify for prime lending due to poor credit histories, low credit scores (generally below 620), limited income documentation, high debt-to-income ratios, or past delinquencies and defaults. Lenders price subprime loans at significantly higher interest rates and fees to compensate for the elevated probability of default. Subprime mortgages grew dramatically during the 2000s housing boom, with widespread origination of adjustable-rate subprime mortgages with low teaser rates that reset sharply after 2–3 years. The collapse of the subprime mortgage market beginning in 2007 triggered the global financial crisis of 2008, resulting in millions of foreclosures and sweeping regulatory reforms under the Dodd-Frank Act including stronger ability-to-repay requirements.
Example
In 2006, a borrower with a 580 credit score and undocumented income obtained a 2/28 adjustable-rate subprime mortgage at 8% for the first two years, scheduled to reset to 11.5% in year three. When the rate reset coincided with falling home prices, the borrower could neither afford the higher payment nor refinance, contributing to the wave of defaults that destabilized the financial system.
Source: FDIC — Subprime Lending