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A subprime loan is a type of loan that's typically offered to borrowers who don't qualify for a prime loan. Subprime is a term used to describe people who have a FICO® Score☉ between 580 and 669—in other words, those with fair credit. As you can probably guess, prime borrowers typically have higher credit scores.
Subprime borrowers present some risk to potential lenders and may not qualify for some loans and credit cards. But they can still often qualify for credit from lenders, depending on several factors. Here's how it works.
How Does a Subprime Loan Work?
Subprime loans are designed for people who are struggling with their credit. Either you're just starting to build credit and you have a "thin" credit file (with four or fewer credit accounts), or you've made some mistakes in the past and are rebuilding your credit history.
Instead of requiring you to wait until you have good or excellent credit to get a loan, subprime loans allow you to get the money you need when you need it.
Subprime lenders offer many of the same loans you can get with good or excellent credit, including subprime auto loans, subprime mortgages and subprime personal loans. Here are some features, though, that can differ:
- Higher interest rates: Subprime loans typically charge higher interest rates than prime loans. Depending on the type of loan, the difference can be a few percentage points or it can be 10 or more. On short-term loans, this might not be a big deal. But with an auto loan or mortgage, it could mean thousands or even tens of thousands more in interest charges.
- Larger down payments: Auto and mortgage lenders typically require a larger down payment to help make up for the higher level of risk with subprime loans. With a car loan, for instance, you may need to put down 10% or more rather than 0% to 5% as a down payment, which is typical for borrowers with good or excellent credit. And while personal loans don't require a down payment, you may need to put up your savings as collateral in the event that you default.
- Higher fees: Subprime loans are more likely to charge origination fees than prime personal loans, and you may also see steeper late-payment fees.
The Difference Between Subprime and Prime Loans
A subprime loan works similarly to a prime loan in terms of the general setup. The primary difference is that subprime loans tend to charge higher interest rates, and may also charge certain fees you might not see with prime loans.
This happens because of risk-based pricing, which is a method lenders use to determine interest rates and other terms based on your creditworthiness. The more likely you are to default—in the lender's eyes, at least—the more a loan can cost in terms of interest and fees.
With a relatively short-term loan, such as a personal loan, the difference in overall cost might not be too wide. But on a subprime mortgage loan with payments spread over 30 years, the difference could cost you tens of thousands of dollars more.
As a result, it's important to carefully consider whether you need a loan now or if you can afford to wait until your credit has improved and you have a better chance of qualifying for a prime loan.
How Do I Get a Subprime Loan?
The best places to go for a subprime loan depends on the type of loan you're looking for. You may choose to look at traditional lenders like big banks or online lenders that specialize in working with people who have subprime credit. Here are some other steps you can take to find the right loan for you:
- Check with your local credit union: Credit unions are required by law to cap the interest rate on most of their loans at 18%, which is much lower than what other subprime lenders might offer. However, the institution may require that you use your savings or some other asset as collateral to get approved.
- Shop around: Take your time when researching your options. Apply or get prequalified with at least three or four lenders to make sure you get the best terms you can qualify for.
- Get help: If you're looking for a personal loan or auto loan, online tools like Experian CreditMatch™ can help you find lenders based on your credit score, saving you time and potentially giving you more options.
One thing to watch out for when looking for a subprime loan is payday loans. These loans are often marketed to people with poor or fair credit, but they can make things worse before they help make them better. Payday loans are typically due within 14 days and have astronomical interest rates, making them worth avoiding in general.
How Do Subprime Loans Affect Credit?
As with any other loan, a subprime loan can have a positive effect on your credit score, as long as you make your payments on time. That said, it can have the opposite effect if you miss payments or default on the loan altogether, so it's important to have a repayment plan in place.
Also, it's important to check with a lender before you apply to make sure they report your account activity to all three national credit reporting agencies. That way you can ensure you'll get credit for maintaining the loan responsibly.
Some lenders only report to one or two credit reporting agencies, and some might not report at all. If a lender doesn't report to all three, it may be worth looking elsewhere to ensure that your hard work gets the credit it deserves.
Also, keep in mind that if you manage your subprime loan well, it can help improve your credit score and give you a better chance to qualify for a prime loan with better terms the next time you need to borrow money.
Stay on Top of Your Credit Scores
Whether you decide to get a subprime loan now or to wait until you qualify for a prime loan, it's important to know where your credit scores stand at all times. Check your credit score regularly to get an idea of how different actions you take affect it.
As you notice improvements over time, you'll not only have the motivation to continue practicing good credit habits but can also learn other ways to build and maintain a good credit score for the long term. This will give you the chance to have better access to favorable terms on future loans and credit cards.