Lenders try to look very carefully at the credit risk of their borrowers in the hope of predicting whether the borrowers will default on the loan. People with very good credit, or the absence of certain red flags that send warning signs to lenders, are referred to as prime borrowers, and the loans that they take are prime loans. Borrowers who are more likely to default are referred to as sub-prime borrowers, and the loans they take out to finance a home are subprime mortgages.
There is no standard definition for what exactly constitutes a subprime loan. Typical methods of making that determination include the use of a credit score or by using certain proxies for credit risk.
Credit scoring companies scour consumers’ histories and then assign a numerical value to the creditworthiness. The most frequently mentioned score is FICO, the Fair Isaac Credit Organization. The credit score calculations try to take dozens of factors and assign a standardized number to capture credit risk. Credit scores in the high 700s or over 800 are considered near flawless. Lower 700s are marginal. And scores below 640 are often considered sub-prime. Although there is no hard and fast rule, a borrower with a score below 640 is most likely in the subprime category.
Some lenders avoid using the score as a single predictor of default risk and instead focus on a handful of particularly troubling credit events to categorize borrowers as subprime. Examples of the types of things in a borrower’s history that can make them sub-prime include bankruptcies, defaults, excessive chargeoffs, histories of extensive delinquencies, or huge debt amounts. It is possible that somebody could have a relatively high credit score and still have one of these ghosts in their past, especially if the event was a long time ago. Some lenders choose to use these red flags as the indicator of default risk, and categorize the borrowers as subprime because of it, instead of the score.
The implications for a sub-prime borrower can be severe. During the credit crunch of 2007 to 2010, many lenders simply stopped lending to anybody with a subprime score, and in fact many also started restricting credit availability to those who had low scores, making their financial situations worse. Even if a sub-prime borrower can get a loan, they will almost always pay a higher rate for it. Lenders attempt to spread their risk of default among all borrowers, and a prime lender who represents little risk of default will be given a rate that reflects that low likelihood. On the other hand, subprime borrowers are charged more so that the costs to the lender in the event of default are paid by the higher rates that the subprime borrowers all chip in to pay.
There are ways to climb out of the sub-prime rating. First, time heals all wounds, including credit wounds. A late payment becomes less worrisome after many months of on-time payments. Paying down credit balances also removes the appearance that a borrower is living precariously close to the edge of a credit black hole. Finally, some bad events like defaults will remain on a credit report for as many as seven or ten years before they drop off.
Subprime mortgages have become a household term, but the concept is not new. Some credit risks are worse than others, and lenders, including mortgage lenders, try to assign potential borrowers by the amount of risk that they pose to the bank. Those who have less than ideal records will find themselves labeled subprime, and this will increase the difficulty and the cost of obtaining credit.