What is a sub prime car loan?
Subprime car loans—as well as subprime mortgages and credit card lending—do not have a firm definition. A subprime loan is in contrast to a prime loan, which is a loan given to an exceptional borrower on a lender’s best terms. Subprime loans are loans offered to borrowers who have some challenges in their credit history.
Because these loans represent a greater risk to the lender, they typically come with a higher interest rate. However, subprime loans also offer financing to borrowers who would not otherwise qualify for a loan.
What would classify a borrower as subprime?
When a lender considers a loan application, the primary focus is determining the likelihood of loan repayment. If a lender believes a borrower is less likely to repay a loan, it represents a greater risk, and the loan will have a higher interest rate, or not be approved at all.
Common reasons a borrower might be classified as subprime include:
History of late or outstanding payments on other debt. Late payments on credit cards, mortgages, and other loans may be reported to credit bureaus. These late payments have a negative effect on your credit score, which is one metric a lender uses to judge creditworthiness of a borrower. Late payments in your recent credit history have a greater impact than those from years’ past.
Bankruptcy. Personal bankruptcy can occur for many reasons, from irresponsible borrowing to an unforeseen medical expense or job loss. Borrowers with a bankruptcy may still be able to obtain a subprime loan. An important factor is whether failure to repay an auto loan was part of the bankruptcy, or if the bankruptcy led to repossession of a vehicle. Subprime auto lenders are most interested in your history of maintaining on-time car payments.
A high debt-to-income ratio. Even if a borrower has made payments on time, a lender may not offer a prime rate because of a high debt-to-income ratio. This ratio compares a prospective borrower’s total debt to current income. If a lender feels that a borrower is overextended (typically when the debt-to-income ratio exceeds 50%), the lender may offer a subprime rate because additional debt could tip a borrower over the edge.
Unemployment or inconsistent work history. Some borrowers may not have outstanding debt or a history of late payments but still qualify as subprime borrowers because of an inconsistent work history. Lenders know that a stable income is a major factor in likelihood of repayment. A consistent, two-year work history is a general guideline lenders use when determining the stability of employment.
Specific factors for subprime auto loans
Subprime lending occurs for home mortgages and credit cards as well as auto loans. In the subprime lending industry, subprime mortgages represent the least amount of risk to the lender because the house acts as collateral. Home values generally rise over time, protecting the bank from losses caused by default or bankruptcy.
A subprime auto loan offers some collateral to the lender, in the form of the car used for the loan. However, cars are depreciating assets—their value decreases over time—meaning lenders take greater risk. Credit cards offer consumer financing with no collateral, placing lenders at greatest risk.
While your credit history many not qualify you for prime rates, financing through a subprime auto loan may still be possible. If you’re able to find a car and payment plan that works for your budget, a subprime loan can solve your transportation needs and start the process of rebuilding your credit—so that your next auto loan comes on near-prime or prime terms.
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