SUBPRIME LENDING

Q: What is 'Prime Lending Rate'?

Q: What is 'Prime Lending'?
Prime Lending Rate:
● PRIME LENDING RATE is the interest rate that commercial
banks charge on loans to their most favorable, credit-worthy
customers.
● Default risk is one of the primary determiners of the interest
rate that a bank will charge a borrower. Since loans to credit-
worthy customers carry a low risk of default, the prime rate is
typically the lowest rate of interest on bank loans at a given place
and time.
● The prime lending rate is also used as a reference rate, and is
used to calculate the total rate of interest on loans. The
bank's most creditworthy customers borrow at rates below the
prime rate.
The total interest rate on such loans is calculated as follows:
Total Interest = Prime Rate + SPREAD; where: Prime Rate is
Variable Spread is fixed
● Commonly used reference rates include: 1. Wall Street Journal
Prime Rate
2. London Interbank Offered Rate
(LIBOR)

● Thus, 'Prime Lending' and 'Sub-prime Lending' can be defined as

follows:
PRIME LENDING :
Prime Lending constitutes the loans offered to creditworthy
customers with
a low risk of default. These loans are offered at prime lending
rates, which
are comparatively lower.

SUB-PRIME LENDING :
Sub-prime lending constitutes the loans offered to customers with
low
credit-worthiness, and carry a high risk of default. These loans are
offered
at high interest rates, to offset the high risk of default.
Prime Lending v/s Sub-prime Lending:

Parameter Prime Lending Sub-prime

Lending
Creditworthiness of High Low High
Borrower Low High
Risk of DefaultInterest Rate Low Low
Subprime Lending – An
Overview
● WHAT IS SUB-PRIME LENDING AND WHO DOES IT SERV E?
Subprime lenders offer mortgages to people who represent a
higher
level of risk than borrowers who meet standard prime
underwriting guidelines.
Subprime borrowers do not qualify for market interest rates owing
to various risk factors, such as, income level, credit history,
employment status, size of the downpayment made, etc.
In general, there are three different types of products offered to
subprime borrowers:
● Home purchase and refinance mortgages targeted to borrowers
with
poor credit histories. Refinance mortgages account for a larger
share of
these loans: over 80 percent of loans originated to borrowers are
for
refinance purposes. In a majority of cases, borrowers refinance
mortgages for an amount greater than the unpaid principal on the
original mortgage, thereby taking “cash out” of the transaction;
● High loan-to-value (LTV) mortgages, originated to borrowers with
relatively good credit, but with LTV ratios that sometimes exceed
150
percent. These loans are refinance mortgages.

Subprime borrowers are more likely to have low incomes and/or a

weak credit history. Subprime borrowers in general also tend to be
less financially knowledgeable and sophisticated and less
comfortable dealing with banks. Underwriting standards in the
subprime mortgage market vary from lender to lender and are not
guided by secondary market standards as in the prime mortgage
market. As a result, it is difficult for borrowers to determine
whether or not a loan offered by a subprime lender is the best
loan for which they qualify given their individual risk profiles.

● A BRIEF HISTORY OF SUBPRIME LENDIN G

● Subprime lending grew rapidly in the 1990s. Between 1993 and
1998,
subprime lending increased 760 percent for home purchases and
890
percent for refinance mortgages; during the same period the
prime market
grew 38 percent and almost three percent, respectively.
● The subprime market’s growth can be attributed to a number of
interrelated
factors. These include:
Federal Legislation Preempting State Limits on Mortgage Terms
The National Economy and Accompanied Increases in Property
Values
Increased Levels of Consumer Debt
Technological Developments
Changes in Financial Markets
Search for Increased Profits
Excess Capacity Among Lenders
Some of these factors are discussed below.