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What is a subprime loan?

Borrowers with a good credit history can borrow money at "prime" rates, the lowest lending rates available. A subprime loan is for people with a less than perfect credit history and these loans are written at higher interest rates, sometimes substantially higher. Due to their higher costs, subprime loans are best used to help establish or reestablish a good credit history.

Until the early 1990s, it was nearly impossible for borrowers to obtain a mortgage if they did not have an excellent credit history. They needed to qualify for either a government guaranteed loan or a conventional loan. In response, the subprime lending market evolved to help "credit impaired" borrowers acquire a residential mortgage loan. There are many legitimate reasons reasons why borrowers fall behind on scheduled payments and end up with a poor credit record, unexpected loss of employment or a catastrophic injury or illness for example. Subprime loans offer a lender the latitude to consider events outside the borrower's control when making lending decisions. The human touch has finally been added to the mortgage loan industry!

Why consider a subprime loan if they are more expensive? Here are several reasons:

New home buyers can get into the home they want at today's prices instead of waiting until their credit history improves. Once in the home, they have an opportunity to establish or reestablish their credit and ultimately, refinance at a lower rate a few years later.

A borrower who already has a mortgage can refinance to cash out equity in his home. He can use this cash to pay down higher rate credit cards or catch up on past due bills. It's a good way to clean up a troubled credit history, reduce monthly expenses and get back on your feet.

Subprime loans are normally for the short term, perhaps 2-5 years. Smart borrowers will clean up their credit history during that time and refinance at a lower interest rate, after their credit record is substantially improved.

Unlike the conventional mortgage market, subprime loan costs often vary widely from lender to lender, with rates and terms all over the map! Borrowers must learn how to shop for a loan before they commit or risk "getting taken to the cleaners!"

In the conventional mortgage business the rules are fairly cut and dried and there's little variation in the credit risk involved from borrower to borrower. But in the subprime business, every loan is individual and every borrower's history is unique. A loan officer must assess the risks inherent in making each loan and price the loan accordingly. Since each loan officer may assess the risks differently, the cost of a loan can vary drastically from lender to lender.

In order to get the best deal, subprime borrowers must devote extra time to shopping for a loan, much more time than a conventional borrower might. Each lender will likely offer different rates and fees for similar loans. Subprime borrowers must keep their options open and get quotes from as many lenders as possible.

Subprime borrowers should also hone their negotiation skills because subprime lenders have much more freedom to adjust their rates than conventional lenders. Subprime lenders acquire the money they lend from different sources than conventional lenders, the lending rules governing that money are more flexible, so they have more flexibility to negotiate costs. Careful price negotiations can save a smart borrower thousands of dollars over the life of the loan.

There are less obvious ways savvy subprime borrowers can save money, too. For example, subprime lenders depend primarily on a borrower's FICO credit score when making lending decisions. FICO scores are grouped into a letter grade that typically ranges from "A+" down to "E" and a loan officer usually charges a rate appropriate to the grade. The distinctions between grades are often slight and borrowers can often move up a grade without too much effort.

For example, a borrower with two 30-day late payments on their credit record might be assigned an "A-" grade while having just one late payment would keep them in the "A" zone. As a result, a borrower who has two late payments with one of the late payments from 11 months ago could improve a notch just by waiting a month to borrow. This could save up to a half percentage point on the interest rate charged for the loan.

A slightly bigger down payment can often make a substantial difference in loan costs too. Lenders generally adjust their rates lower for each 5 percent drop in a mortgage's loan-to-value ratio, the difference between the loan amount and the value of the property securing it. Someone with a $100,000 home who wanted to pay off old debt by refinancing could save half a percentage point by borrowing $79,900 instead of $80,100 or more.

Be sure to consider the prepayment penalty too, most subprime loans have them. You might be able to lower your interest rate by accepting a longer duration penalty, such as one that lasts for five years, but this may not fit your financial goals. It's not uncommon for a borrower to improve his credit history enough to qualify for a conventional loan in one or two years but a large or lengthy prepayment penalty could make refinancing too costly before that prepayment penalty expires.

If all of this sounds confusing, it is! We've only discussed a few of the hundreds of things a subprime borrower needs to watch for. How can borrowers protect themselves and get the best deal? We've said it before, get quotes from as many lenders as possible! Ask each lender how you can get a better rate, repeatedly and at every opportunity, until you've beaten them down to their best offer. Question anything you don't understand until you do understand. Lenders will be making plenty of money from your loan, make them earn it!

LoanWeb.com provides free, no obligation bids from several reputable mortgage lenders allowing you to select the offer that best meets your needs, from a variety of lenders. They can simplify your shopping considerably!