Understanding Sub Prime Loans

By: Lesley Lyon

The practice of extending loans to people with deficient credit history and are ineligible for best market interest rates is known as sub prime loans. Due to the combination of high interest rates, bad credit history and adverse financial institutions, sub prime loan are highly risky for lenders as well as borrowers. Sub prime lending includes sub prime mortgages, sub prime car loans, and sub prime credit cards. The credit status of the borrower is termed as "sub prime"

Sub prime lenders take the risk of lending the people with poor credit rating and compensate for this risk by a higher interest rate. If the borrower has a sub prime credit card, he may be charged higher late fees, higher over limit fees, yearly fees or upfront fees and will not be given a "grace period' to pay late fees unlike prime credit card holders.

Sub prime borrowers may utilize the opportunity to purchase home, car or even paying down on a high interest credit card. If borrowers maintain a good record they would be able to get refinance back into the mainstream rate after a period of time called "credit repair"

Sub prime loans can be obtained either as sub prime mortgage or through sub prime credit cards. Sub prime mortgage loans are riskier in that they are offered to borrowers who are unable to qualify under traditional, more stringent criteria due to blemished or tarnished credit history.

Sub prime mortgages can be interest only mortgages (that allow borrowers to pay interest only for a period of time) pick a payment loan (borrowers choose their monthly payment) and initial fixed rate mortgages (quickly converts to variable rates)

Sub prime credit cards:

These cards help a consumer improve his poor credit scores. These cards usually begin with low credit limits and carry extremely high fees and interest rates, as high as 30 percent or more. But now due to high competition in the market, they are forced to reduce the interest rates to as low as 9.9 percent People who have experienced severe financial problems are labeled as "higher risk" and have great difficulty in obtaining credit particularly for large purchases like automobiles or real estates. Due to late payments, charge-offs, repossessions and even foreclosures may result due to unforeseen reasons of financial crisis.

Sub prime borrowers represent a riskier investment and therefore lenders charge them a higher interest rate than for a prime borrower for the same loan. Therefore to avoid the initial hit, most sub prime borrowers opt for adjustable -rate mortgages (ARMs) that offer a lower initial rate. This is, in fact, negative amortization, that is, the borrower pays back less than the full amount of interest owed to the lender every month. The reduced amount is then added to the total amount owed.

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