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Subprime lending (also known as B-paper, near-prime, or second chance lending) is lending at a higher rate than the prime rate. In the US, the term "subprime" in mortgage lending, refers to loans that do not meet Fannie Mae or Freddie Mac guidelines. While often defined or defended as lending to borrowers with compromised credit histories, the Wall Street Journal reported in 2006, 61% of all borrowers receiving subprime loans had credit scores high enough to qualify for prime conventional loans.[1] It may or may not reflect credit status of the borrower as being less than ideal and may not even reflect the interest rate on the loan itself. The phrase also refers to bank loans taken on property that cannot be sold on the primary market, including loans on certain types of investment properties and to certain types of self-employed persons.

Subprime lending is risky for both lenders and borrowers due to the combination of high interest rates, allegedly poor credit histories (which can be extraordinarily inaccurate) and potentially adverse financial situations that are sometimes associated with subprime applicants. A subprime loan is offered at a rate higher than A-paper loans due to the perceived increased risk. Subprime lending encompasses a variety of credit instruments, including subprime mortgages, subprime car loans, and subprime credit cards. The most abusive subprime lending practices are, arguably, short-term "payday" loans.

Subprime lending is highly controversial. Opponents alleged subprime lenders engaged in predatory lending practices such as deliberately targeting borrowers who could not understand what they were signing, or lending to people who could never meet the terms of their loans. Many of these loans included exorbitant fees and hidden terms and conditions, and they frequently lead to default, seizure of collateral, and foreclosure.

There have been charges of mortgage discrimination on the basis of race.[2] Proponents of subprime lending maintain that the practice extends credit to people who would otherwise not have access to the credit market.[3]

As the result of an ongoing lending and credit crisis in the subprime industry, and in the greater financial markets which began in the United States, the controversy surrounding subprime lending has expanded. This phenomenon has been described as a financial contagion which has led to a restriction on the availability of credit in world financial markets. Millions of borrowers are making inflated payments and cutting back on other parts of their budget. Hundreds of thousands of borrowers have been forced to default or file for bankruptcy. Hundreds of subprime lenders or brokers have closed, some have filed for bankruptcy and several have been acquired.

Background

Subprime lending evolved with the realization of a demand in the marketplace and businesses providing a supply to meet it coupled with the relaxation of usury laws and an unwillingness on the part of legislators at the national level to recognize the inherent risks to consumers. Traditional lenders are more cautious and have turned away a record number of potential customers.[citation needed] Statistically, approximately 25% of the population of the United States falls into this category.[citation needed]

In the third quarter of 2007, subprime ARMs only represented 6.8% of the mortgages outstanding in the US, yet they represented 43.0% of the foreclosures started. Subprime fixed mortgages represented 6.3% of outstanding loans and 12.0% of the foreclosures started in the same period.[4]

The American Dialect Society designated the word "subprime" as the 2007 Word of the year on January 04, 2008. [5]

[edit] Definition

Fannie Mae has lending guidelines for what it considers to be "prime" borrowers on conforming mortgage loans - those loans they will buy or securitize into the credit market. Their standard provides a good comparison between those who are eligible for prime vs. subprime loans. Eligible borrowers for prime loans have a credit score above 620 (credit scores are between 350 and 850 with a median in the U.S. of 678 and a mean of 723), a debt-to-income ratio (DTI) no greater than 75% (meaning that no more than 55% of net income pays for housing and other debt), and a combined loan to value ratio of 90%, meaning that the borrower is paying a 10% downpayment.

[edit] Subprime lenders

To access this increasing market, lenders often take on risks associated with lending to people with allegedly poor credit ratings. Subprime loans are considered to carry a far greater risk for the lender due to the aforementioned credit risk characteristics of the typical subprime borrower. Lenders use a variety of methods to offset these risks. In the case of many subprime loans, this risk is offset with a higher interest rate or various credit enhancements such as Private Mortgage Insurance (PMI). In the case of subprime credit cards, a subprime customer may be charged higher late fees, higher over limit fees, yearly fees, or up front fees for the card. These late fees are then charged to the account, which may drive the customer over their credit limit, resulting in over limit fees. Thus the fees compound, resulting in higher returns for the lenders.

[edit] Borrower profiles

Subprime can offer an opportunity for borrowers with an allegedly less than ideal credit record to gain access to credit. Borrowers may use this credit to purchase homes, or in the case of a cash out refinance, finance other forms of spending such as purchasing a car, paying for living expenses, remodeling a home, or even paying down on a high interest credit card. However, due to the risk profile of the subprime borrower, this access to credit comes at the price of higher interest rates, increased fees and other increased costs. Some of these costs are often hidden to the borrower. On a more positive note, subprime lending (and mortgages in particular), allegedly provide a method of "credit repair"; if borrowers maintain a good payment record, they should be able to refinance back onto mainstream rates after a period of time. In the UK, most subprime mortgages have a two or three-year tie-in, and borrowers may face additional charges for replacing their mortgages before the tie-in has expired.

Generally, the credit profile keeping a borrower out of a prime loan may include one or more of the following:

* Two or more loan payments paid past 30 days due in the last 12