Prime and subprime loans have a lot of differences. They are on the opposite ends of the spectrum. Though a subprime lender may set his own requirements, it can still be greatly affected by how prime loans are doing in the market. This is evident most especially on the rates subprimes take.
Defining a Prime Loan
Before we discuss on how prime rates affect subprime loans, let us first define what a prime loan is. A prime loan may also be called a conventional loan. In the strict sense, it is a loan that is not guaranteed or insured by any US government agency. It is mostly offered by private lending institutions, banks, and credit unions. Experts, though, have said that government-insured loans are not far from conventional loans as requirements, terms and rates are most likely the same for both.
For a borrower to be eligible for a prime loan, there are standard requirements to be met: down payment, income and credit score. If you fail to meet any of these requirements, you may be declined or be offered to pay for a higher interest rate or a larger down. Most conventional loans have fixed terms and rates. Prime loan rates are primarily determined by the federal funds rate.
Subprime, by Definition
Otherwise called as a non-prime or second-chance loan, a subprime loan is a program for people who would not qualify for a prime loan. Unlike prime loans, it does not need verification in income, assets and credit score. You may have a bad credit score, or may be unemployed, or may not enough in your bank accounts and still get approved for the loan. For these people, this loan may mean the second chance to finally get the financing they need.
If prime loan rates are typically fixed, subprime rates are the opposite. This is because rates are calculated on a risk-based pricing. The rates may also balloon at the end of the loan. This is because the lender sets the rules.
How is Subprime Affected by the Prime Rate?
Subprime interest rates, as we know it, aren’t set in stone. Because risk-based pricing applies, different lenders may see a borrower’s risk differently. This is why subprime rates are so varied, but it is always higher than the prime rate. Prime rates are determined by the federal funds rate. This is when banks lend money from one another overnight. This is done by so that banks can meet their fund reserve requirements. This rate then determines the rate the borrowers are charged on. Put simply, the higher the federal funds rate, the more expensive it is to loan some money.
Normally, big loan companies and other financial corporations and institutions have rates that fall close to the prime rate. Retail lenders who fund small loans receive rates a little bit higher than this rate. Note, though, that it is still based on the prime rate. Now, where does a subprime loan base its rates? There are a few factors that play a part such as a borrower’s low credit score. Another factor that determines the rates is the prime rate. A subprime rate is significantly higher than the prime rate.
It is virtually impossible for a subprime rate to be lower than the prime rate. Why is this? This rate is, again, risk-based. Meaning, the worse the credit, the more expensive the loan. It’s lax approach on poor credit scores and income and asset verification makes this loan expensive and not for everyone.
Subprimes loans, though, have made financing available to people who would not be eligible for a conventional loan. A significant number of home purchases and mortgages, in fact, have been funded through this type of loan. An array of benefits awaits those who consider a subprime. But to reap its rewards, you need to study for this loan type be of help to you. One article on this site shortlists those who can benefit from this loan the best, read on it to aid you in your research. And while you do that, shopping for lenders is also a good way to find the lowest subprime rate you can find.