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Subprime Lending: What You Need to Know

Subprime lending means loans to customers with less-than-perfect credit histories. For example, someone with an irregular income who fell behind on bills, or made one or more late payments on a credit card. The recent rise in subprime lending has been driven by a rise in the number of Americans with imperfect credit histories. One reason is that lenders today have the ability to routinely check borrowers' credit files, often years after an initial application for credit is approved. In addition, more types of bill-paying data are available today, such as records from utilities and hospitals. This makes it more likely that creditors will find some type of credit "ding" (e.g., one late payment) which can be used to reclassify borrowers as subprime.

Not too long ago, many subprime borrowers probably would not have even qualified for a loan or credit card. Today, however, they are aggressively extended credit, but at a high cost. An estimated 30% of the U.S. population was considered subprime at the end of the 1990s, compared to 20% at the beginning of the decade. In addition to those with credit blemishes, some subprime borrowers (e.g., young adults and immigrants) simply lack a credit history. They are simply "invisible" to lenders because there is nothing in their credit file.

Below is the meaning of the credit tier ratings that are generally used by lenders:

A - All bills paid on time
B - At least one bill paid by as much as 30 days late
C - One or more bills overdue for 30 to 90 days
D - At least one bill sent to a collection agency or written off (e.g., bankruptcy)

Credit scores are three digit numbers that range from the 300s (worst) through the 800s (best). They are sometimes called FICO scores. FICO is an abbreviation for Fair, Isaac, and Co., a California company that develops credit risk scoring models. Most (80% to 85%) consumers score between 600 and 800. The exact threshold for an "A" (prime) borrower varies among lenders but is typically between 620 and 660. Many lenders also divide consumers with prime credit scores into several different "subtiers" (e.g., A1, A2, A3) and charge each a different interest rate.

Credit scores are determined by using statistical risk models. FICO develops these models after determining factors that affect bill-paying behavior. Each of these factors is given a weighting in the statistical model based on how much they influence payment behavior. Some of these factors include whether previous bills have been paid on time and the amount of a borrower's outstanding debt.

Credit scores are available online for a $12.95 fee, which includes a credit report, from the credit bureau Equifax (www.equifax.com) and from Fair, Isaac, and Co. (www.myfico.com). They are also free from the Web site #34;>www.eloan.com. Risk classifications vary among lenders, however. In other words, a consumer can have a different rating with different lenders with the same credit score. Different lenders have different "cutoff" numbers so someone could be rated higher by one lender than another.

Over time, the difference in interest rates and monthly payments between prime and subprime loans, can be thousands of dollars, especially for long-term loans. The monthly payments on 11% and 15.25%, 10-year, $40,000 loans are $551.01 and $651.48, respectively. This is a difference of $100.47 per month and $12,056.40 (120 payments x $100.47) over the life of the loan.