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How Do Subprime Loans Work ?
Before one can understand how a subprime loan works, it is essential to know what a prime loan is. Lending in the United States as well as in most countries mainly depends on the borrower’s credit score. |
A credit score is basically a representation of an individual’s history regarding payment of previous loans, payment of credit card bills, debts, monthly income, capacity to pay back loans etc. Therefore, someone with a high credit score is a good borrower, or a prime borrower, someone who is very likely to pay his loan back to the lender without defaulting. This kind of loan is a good or a prime loan.
What this means is that people with poor credit scores are not handed loans, because there is a very good chance that they will default on their loan, and the lender will, therefore, lose his money. But once every person with a good credit score already having a loan, lenders got greedy, and because there was no one left to loan money to, and so no way to make more money via interest payments, they started lending money to people with poor credit scores, but where some type of collateral might exist, like a house in the case of a subprime mortgages, where the possibility of being paid back was low. To compensate for this risk that they take, lenders usually charge a much higher rate of interest to such people in order to make their money back. This kind of loan is a bad, or a subprime loan.
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