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The term subprime loan is somewhat confusing. Since sub means below, it would be reasonable to assume that a subprime loan is desirable as being below the prime rate of interest offered at a given time. In fact, the opposite is true. The subprime loan is offered at above the prime interest rate, usually because a person’s credit rating is less than perfect and represents a greater risk of the lender not being repaid. This means the person pays more interest on money borrowed instead of less.
Prime is considered the interest rate at which banks and other lenders will offer loans to customers with the best credit rating. Not all lenders can qualify for the best rates, and these rates will vary considerably based on the market and the type of loan. A subprime loan can also vary considerably. In fact, most financial advisors suggest shopping around if you can only qualify for a subprime loan since each lender may have different criteria for determining credit worthiness.
Some financial experts also advise not taking a loan if you can only get one at a subprime rate, since you will ultimately pay more in interest than for loans you can get at a prime rate. However, in some cases, it still makes sense to get a subprime loan if the money is really necessary and there is not other way to pay off debts. With the fall in the price of homes in some areas starting in 2006, some people who would have been considered for a subprime loan may not be able to get one.
A number of lenders have focused on loaning money at subprime rates to borrowers with less than perfect credit. The ideal for many of these borrowers, purchasing homes in 2004-2005, was that real estate was booming, and that in a few years of establishing credit worthiness, borrowers would be able to refinance their homes at lower rates. Some took out interest-only loans with high subprime rates, which meant they were not accruing any equity in their homes.
Instead of the housing boom continuing, a significant drop in home values occurred in 2006 and 2007. Many people were unable to refinance their homes for a lower rate, and people with interest-only loans were stuck with greater payments than they could afford, and homes that were actually worth less than they were at time of purchase. The subprime rate didn’t help matters and many people were forced to sell their homes or default on their loans. This situation has caused concern among lenders whose primary customers are those with subprime loans. A high number of defaults on loans due to inability to make high payments have resulted in lenders with less money to lend, and fewer profits.
In 2007, certain lenders instituted more rigid criteria for obtaining a subprime loan, and also have increased the interest rates at which money can be borrowed. This translates to fewer home sales, a continued drop in retail values of homes and a stagnant housing market. On the other hand, making it harder to get a subprime loan may save some people money and create incentives for them to increase their credit scores.
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