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Are Subprime Loans the Right Option for You?

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In a Nutshell

Borrowers with poor or fair credit can't always secure conventional financing but are generally eligible for subprime loans. These loans tend to have high-interest rates and are harder to secure than standard loans. But, when they are the best option available, they can be the right choice for borrowers in need of credit.

Written by Todd Carney, J.D. Harvard Law 2021.  
Updated November 11, 2021


Most American adults have probably heard the word “subprime” before, but many people aren’t sure what it means. Essentially, if you have a low enough credit score, you may be considered a subprime borrower. This can make it harder to get approved for conventional loans. You may be able to get a subprime loan, but these often come with higher interest rates than standard loans do. You’ll also be more at risk of predatory lending. This article explains what subprime loans are and how they impact different loan practices, like mortgage lending.

What Does Subprime Mean?

Subprime generally refers to a borrower who has bad credit or a low credit score. If your credit score is between 580 and 669, it’s considered a subprime credit score. In this case, you’ll likely only qualify for subprime loans. Financial institutions, such as banks and credit unions, provide subprime loans to people with low credit scores. Subprime lending, particularly when it comes in the form of home loans, is considered risky for lenders. This is because subprime borrowers may have missed payments, made late payments, and/or defaulted on previous loans, which is what led to their low credit rating.

Lenders will look at your credit score and credit history to determine whether or not to give you a loan and what the loan’s terms will be. Given this, you should pull your credit report prior to applying for loans so you know where you stand. By law, all three of the main credit reporting agencies must give you a free copy of your credit report each year.

To dig deeper into what determines your score, consider a few different factors: 

  • Payment history determines 35% of your score. This accounts for how on time you have been and currently are on payments, along with any history of bankruptcy. 

  • Your current debt load accounts for 30% of your score. This includes student loans, individual loans and credit card debt, among others. A key factor here is your “credit utilization ratio”, which is how much of your credit limit you have used. So if you have a $500 credit limit and you spend $250, your utilization limit is 50%. It is best to keep your credit utilization ratio below 30%.

  • Your length of credit history makes up 15% of your score. It evaluates how long you’ve had your lines of credit and how you have done in terms of paying off your debt.

  • New credit determines 10% of your score. Each time you take out a new line of credit, your score falls a little. 

  • The types of credit you have account for 10% of your score. If you have a mix of credit, such as a car loan, a student loan and a mortgage, and you have paid these off, your score will improve.

With all of this in mind, if you haven’t been able to pay back loans on time or you have missed payments or made late payments on other debt like credit cards, you might have a subprime credit score. Lenders will look at which category your credit score falls into to get a sense of your creditworthiness and how risky it will be to lend to you. The five categories are: poor credit, fair credit, good credit, very good credit, and exceptional credit. A subprime score is also categorized as a fair credit score, which is the second-lowest category. 

This doesn’t mean that you won’t be able to get a loan, but doing so will likely be more difficult than it would be if your credit score was strong. For example, you might not be able to get a real estate mortgage from a bank, but you can potentially get a U.S. government-backed mortgage, such as an FHA loan through the U.S. Department of Housing and Urban Development (HUD). You can receive other types of loans, but the interest rates will likely be higher unless you can get a co-signer. You will be able to get a credit card, but again, the interest rates will be higher than they would be if you had a strong credit score. 

Pros & Cons of Subprime Loans

Though subprime loans have some drawbacks, they also come with some advantages.  Regardless of your credit score, you probably have financial needs. If you’re in a dire situation and you badly need a loan, a subprime loan will allow you to qualify for the credit you need, even if other lenders won’t approve you.

Additionally, you may have gone through a rough financial patch in your life, but since moved beyond it. If you’re interested in homeownership, but your credit score hasn’t fully recovered, getting a subprime loan can help you realize that dream if you don’t want to wait for your score to improve before you become a homeowner.

That said, there are also many drawbacks to subprime lending.  Subprime loans can catapult someone who is already in a bad financial state into a financial crisis. If you’re behind on your monthly payments now and you take out a loan that you can’t afford, your debt will increase and you’ll also hurt your credit score.

You may also be required to prove that you make a certain income to qualify for these loans. Similarly, you may need to find the cash to make a big down payment or cover higher closing costs.

How To Get a Subprime Loan

As noted above, subprime lending might be your only option if your credit score is fair or poor. If you absolutely need a loan, you should take precautions to protect yourself from the downsides of these kinds of loans:

  • Shop around with different lenders to see who has the lowest interest rates. Just because you will pay a higher interest rate on average, doesn’t mean you have to pay the highest interest rate offered to you. 

  • After you research lenders and compare interest rates, meet with the lenders that make the most sense for your financial situation. You may be able to negotiate a lower interest rate. You’ll also get to see how your repayment plan will function as a whole.

  • Create a budget to make sure that you can pay off the loan. If it will take several years to pay off the loan, use an online loan calculator to see how much you’ll end up paying with interest. You should see if you can cut costs or increase your income long term to make up for the cost of the loan.

  • Finally, consider your alternatives. Ask yourself if you can go without the loan for a little while. If not, consider asking a friend or family member if they’re willing to loan you the money or co-sign the loan for you. Or see if a credit card makes more financial sense.

Types of Subprime Loans

There are three main types of subprime mortgages, subprime car loans, and subprime personal loans. People with poor credit ratings will often make use of all three.

Subprime Mortgages

A subprime mortgage is a type of loan wherein mortgage lenders provide housing loans to homebuyers with poor credit ratings. There are four main types of subprime mortgage loans: 

  1. A fixed-rate subprime mortgage is a loan that will typically last for 40 or 50 years, as opposed to the normal 30 year length. It usually has a higher interest rate than a prime mortgage loan.

  2. An adjustable-rate subprime mortgage (ARM) starts with a low interest rate. But the rate can rise over time.

  3. An interest-only loan allows subprime borrowers to only pay the loan’s interest for the first 5-10 years. Then the loan is refinanced for the next 20 years, and borrowers must make much higher mortgage payments.

  4. A dignity mortgage requires borrowers to pay a high interest rate for the first five years. If all payments are made on time, the lender reduces the interest rate to an average fixed-rate.

Generally, borrowers taking out subprime mortgages are people who have filed for bankruptcy in the last five years or so, those who are dealing with a judgment, or those who have faced repossession or foreclosure within the past 24 months.

With longer term loans, you’ll pay a lot more over time in interest. You’ll also have a larger balance that you will have to deal with if you’re at risk of foreclosure or if you sell the property.

Subprime Auto Loans

Subprime auto loans are car loans given to people with fair credit scores. Borrowers usually have to provide additional information on their financial background, such as bank statements, W-2s or 1099 forms. Similar to subprime mortgages, you will likely have to pay higher interest rates, which will result in higher monthly payments and potentially larger fees as well. If you have a fixed budget, this can all cause you to fall behind on your loans and ultimately risk having your car repossessed. Repossession is quite common with subprime auto loans.

Additionally, your loan might have a prepayment penalty. This means that if you improve your financial situation and want to pay the loan off early, you may be charged a penalty. Paying the loan off early helps you avoid the costs of high interest payments and may save you money. While it’s hard to predict if your financial situation will improve, it’s best to avoid loans with prepayment penalties when possible.

Subprime Personal Loans

If you have a fair credit rating, you may qualify for a subprime personal loan. These loans are unsecured, meaning that they aren’t backed by collateral like a house or car. A lack of security plus a low credit score means that these loans come with high interest rates and fees. These increased rates and fees can cause your debt to further snowball, particularly if you are currently navigating a financial crisis. While it may be the best option for you if you are facing a financial emergency, you should still think carefully before taking out this kind of loan.

How To Make the Most Out of Your Situation

Having a subprime credit rating can cost you. While it’s good to have subprime lending to fall back on, you should take steps to improve your credit score to have better lending options in the future.

To repair your credit, you should consider taking the following steps:

  • Always make your payments on time (if you can’t, consider getting credit counseling help or think about filing for bankruptcy)

  • Run your credit report and dispute any errors

  • Keep your credit utilization ratio low

  • Don’t close out old accounts

  • Don’t take out new loans that you can’t reliably pay back

Let's Summarize…

If your credit score is between 580 and 669, you’re likely considered a subprime borrower. Having a subprime credit score will make it difficult for you to receive conventional loans. You may be able to get a subprime loan, but these loans often come with higher interest rates and other fees. There are subprime mortgages, auto loans, and personal loans available if you need them. If you need to engage in subprime lending, you should compare interest rates and other factors between lenders to get the best deal. Also, you can speak with a credit counselor for free. They can help you make an informed decision about your options.



Written By:

Todd Carney, J.D. Harvard Law 2021

LinkedIn

Todd Carney is a writer and graduate of Harvard Law School. While in law school, Todd worked in a clinic that helped pro-bono clients file for bankruptcy. Todd also studied several aspects of how the law impacts consumers. Todd has written over 40 articles for sites such as RealC... read more about Todd Carney, J.D. Harvard Law 2021

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