You have heard that subprime loans are bad…but do you know why?
Here’s the truth about those “easy approval” loans.
WHAT ARE DIFFERENT TYPES OF SUBPRIME LOANS?
-Payday / Salary / Payroll loans or advances.
-Rent to Own Items (furniture, electronics, etc).
-Easy or Quick Cash Loans.
-“No Credit/Bad Credit” Auto Loans.
…to name a few.
WHAT IS SUBPRIME LENDING?
The term “subprime” refers to the credit quality of particular borrowers who have weak credit histories and/or a greater risk of loan default (non-payment) on paper than “prime” borrowers.
WHAT MAKES YOU A SUBPRIME BORROWER?
In the eyes of a lender, a subprime borrowers might have any of the following…
-Limited credit: You may not have much or any credit. This means that the lender doesn’t know how you handle debt repayment, so they have to assume the worst. Guilty until proven innocent.
-No Assets: The lender has nothing to sell and recoup losses in the event you default, such as a car or house.
-Excessive Debt: Your income looks unlikely to be enough to pay for living expenses, other debt/loans you have, and the proposed loan. Historically, this increases the risk that you might bite off more than you can chew with a new loan and enter financial hot water.
-Missed Payments: You have a history of missed payments, or late payments.
-Default: You have a history of loans being sent into collections, being charged-off, or bankruptcy.
HOW DO THEY WORK?
Here’s a simple explanation on how one of the more complicated subprime loans (a payday loan) works, courtesy of allfinancialmatters.com
The typical payday loan is a two-week loan. The fee for such a loan is $15 to $25 per $100 borrowed (that’s for TWO WEEKS)
Let’s say times are tough and Jack needs $100 to fix his car. Jack goes down to the local payday loan company and they agree to give him a loan. Jack writes a check for $125 and gives it to the payday company and they give him $100. Two weeks later, Jack gets paid and the payday loan company cashes Jack’s check, closing out the deal.
Title loans operate in this same fashion, but use your vehicle as collateral instead of your paycheck. If you can’t pay the title loan back, and do not renew the loan, they will repossess your vehicle.
WHY ARE SUBPRIME LOANS BAD?
Cost. Plain and simple. These loans often come with extremely high interest rates, fees, and/or short repayment plans. Often, many people become “trapped” in a very expensive cycle of subprime loans where they end up paying many times more than the loan was originally for. Users of payday/title lending often get trapped in a cycle of renewing their loan every week until they have enough money to pay it off in full. This creates a vicious trend that can cost thousands of dollars.
Lenders are federally capped at extending loans that exceed a certain annual interest rate (commonly, 30%). Some subprime lenders utilize a workaround by offering a monthly-rate under 30%, and various charging fees to make up the revenue.
An insider secret about the interest rates that a subprime lender charges is this: Annual vs Weekly.
When you break down the APR (Annual Percentage Rate) on the payday loan in the previous segment.. it comes out to 651.79% per year, because a payday lender will charge interest by the week…NOT by the year, like a traditional lender will.
Many experts would also agree that numerous subprime lenders prey on the under banked (somebody who doesn’t have access to or understand how traditional lenders work) and uninformed consumer.
The vast majority of subprime loans do not report to any of the three credit bureaus, meaning that the borrower cannot establish a better credit history, which will keep them from qualifying for lower cost loans through other avenues in the future.
Rather than helping them weather a financial need and offer education for better financial performance in the future, subprime lenders may spread misinformation that renewing or re-signing for another, high cost loan, is the best or only way to improve their financial situation.
WHY ARE SUBPRIME LOANS GOOD?
Financial emergencies happen, and we’ve all needed money to fix a car, pay a doctors bill, or take care of some unforeseen expense. Just because you don’t have strong credit, access to loans/credit, or tons of assets to secure a new loan doesn’t mean that you’re exempt from needing money quickly.
Subprime loans serve a necessary economic market of people who need short term loans and are unable to obtain them through traditional means, plain and simple.
SO, TRADITIONAL LENDERS ARE BETTER, RIGHT?
Yes, and no.
Traditional lenders offer substantially (exponentially, even) lower fees, interest rates, and costs. However, a traditional lender will be more stringent upon your borrowing capacity, and will sometimes have less flexible terms.
What does the bank look for when I apply for a loan? — Check out our article HERE
In nearly every case, a subprime loan will actually make things worse. However, in some situations, a payday loan might be cheaper than bouncing a check, accruing non-sufficient fund fees, or late fees through your financial institution or debtor.
WHAT IS THE BEST THING TO DO?
The absolute smartest thing you can do to protect yourself is to build an emergency fund so you have the cash to handle an unexpected expense. Learn how, the easy way, by clicking HERE.