How Subprime Lending Works
Subprime lending is providing loans to borrowers with below average creditworthiness. Not just for mortgages, subprime lending is associated with all lending instruments, from car loans to credit cards, and so on.
How the Lender Sees It
Different lenders view subprime lending differently.
Some view it in terms of the practices of the lender itself. The U.S. Department of Housing and Urban Development (HUD) for example uses interviews with lenders and data provided by the Home Mortgage Disclosure Act (HMDA) to identify those lenders that are considered as specializing in subprime mortgages. It is worth noting that many prime lenders will still sometimes provide subprime mortgages, and many subprime lenders may also offer prime mortgages.
Whereas other lenders view subprime lending as it applies to attributes of the borrower. A subprime borrower is characterized as having one or more of the following characteristics:
- a record of bankruptcy, foreclosure, or other monetary delinquency in the past
- poor credit
- a high debt-to-income ratio (such as more than 50%)
The 3 C's of Lending
In general, however, the same criteria that have been used since time immemorial for determining whether or not to loan someone money under any conditions apply today. They are known by lenders as the three C's and they are:
- Credit - can the borrower display a history of creditworthiness
- Capacity - can the borrower's current financial situation (income and expenses) support repayment of the debt according to the contract terms
- Collateral - does the collateral being offered (in the case of a mortgage, this is the home itself) have enough intrinsic value to protect the lender's interests in case of borrower default
Even for subprime mortgages, these same criteria are applied, only with less stringency and more leeway. The price for this leeway, of course, is a more expensive loan, but if you can represent two of the above three criteria well, or somewhat represent all three, then there's a good chance you could at least get yourself approved and into the home of your dreams.
Variations on a Theme
Traditionally subprime lending was provided to:
- people with Capacity but not Credit - such as someone who recently defaulted on a debt but now has enough of an income to justify taking on a new debt
- people with Credit and Capacity but poor Collateral - in terms of mortgages, this was (and still is) often the case with non-traditional homes, such as multi-family buildings, rural properties, manufactured homes, mixed-use properties (urban combination residential/commercial buildings), and housing considered generally substandard
More recently, however, subprime lending extended itself to make loans to those without Capacity or Credit based mostly on the value of the Collateral. Though this is not being practiced very much anymore, the effects of having done so recently have already taken hold , contributing in large part to the subprime mortgage crisis we face today.