All You Need to Know about Subprime Personal Loans

Kate’s 540 credit score was holding her back. After losing her job during the pandemic and dealing with an auto accident that required major repairs to her car, she struggled to get a loan that would allow her to get back on her financial feet.

But with a carefully chosen subprime personal loan and a disciplined repayment strategy, Kate gradually rebuilt her credit. Two years later, her score had climbed to 660, opening doors to better financial opportunities.

Facing a low credit score, borrowers wrestle with critical questions: Can I qualify for financing? What are the true costs? Will this loan help or harm my financial future? How can I avoid predatory lending traps?

This guide provides comprehensive answers, offering a roadmap to navigating subprime loans wisely and rebuilding financial health.

What are Subprime Personal Loans and How Do They Work?

Subprime personal loans are designed for borrowers who are not eligible for a traditional loan, due to their suboptimal credit history. 

A subprime personal loan caters to individuals with one or more of the following limitations in their financial profile:

• low credit score (see below)
• limited credit history
• recent bankruptcy or foreclosure
• inconsistent employment history
• high medical expenses

Credit Score Ranges for Subprime Borrowers

An individual’s credit score is critical in determining their eligibility for a subprime personal loan. Different scoring models, such as FICO^® and VantageScore^®  define subprime credit eligibility somewhat differently.

Lenders typically define subprime borrowers as those with credit scores in the ‘Fair’ range, whether using FICO^® or VantageScore^® models. 

From the table above, you can see that the ‘Fair’ credit score range differs slightly from FICO^® (580‒669) to VantageScore^® 4.0 (601‒660). This means that, in order to qualify for a subprime personal loan, your FICO^® score must be a minimum of 580, whereas your VantageScore^® 4.0 score needs to be at least 601.

Keep in mind, though, that the minimum requirement is flexible across lenders, and there are institutions that accept lower credit scores for subprime loan applications.

Check out this helpful resource on building your credit score (back up).

Mitigating Subprime Risk: Lender Strategies

Credit scores take into account multiple factors including payment history, credit utilization, and account age. Borrowers in the subprime range are often characterized by financial challenges, past delinquencies, high debt-to-income ratios (see section below) or limited credit experience. 

While extending credit to such an individual, lenders try to offset the increased risk to themselves by:

1. charging higher interest rates
2. levying extra charges (see section below on loan terms and conditions)
3. building in terms that bump up the final repayment amount  

What this means is that anyone considering a subprime personal loan needs to evaluate both their situation as well as the loan terms and conditions carefully in order to make a prudent decision.  

Common Types of Subprime Loans

Despite credit challenges, subprime loans span several financial categories that cater to borrowers’ diverse needs. The most widely sought categories of subprime loans include:

Subprime personal loans

Unsecured subprime personal loans are used for various purposes, such as covering medical or other emergencies or consolidating debt. Borrowers pay higher costs due to their credit profile, but these loans can serve as a credit-building tool when managed responsibly.

Subprime auto loans

Auto loans are among the most common subprime loans, enabling borrowers to purchase vehicles despite low credit scores. These loans nearly always carry higher interest rates and added fees compared to typical car loans, reflecting the lender's increased risk.

Subprime mortgages

A subprime mortgage provides the opportunity of home ownership to those who cannot qualify for a conventional loan. Typical subprime mortgage features include a higher interest rate, adjustable-rate terms and a longer repayment period. While these loans help borrowers achieve housing goals, they can lead to significant financial strain if not managed carefully.

Subprime credit cards

Subprime credit cards typically come with low spending limits and high fees, but offer an avenue for rebuilding credit through responsible usage. For individuals who can manage to put together the initial security deposit, secured credit cards are often a more cost-effective alternative.

The Pros and Cons of Subprime Personal Loans

Subprime personal loans can be a useful tool for rebuilding finances.

However, choosing and navigating a subprime personal loan requires careful management to avoid potential pitfalls. Borrowers should weigh the major advantages and disadvantages (see table below) of taking out a subprime loan, based on their individual circumstances.

Are Subprime Personal Loans Right for You? Factors to Consider

Determining whether a subprime loan is the right choice requires careful evaluation of your financial situation and the loan terms. The 4-step process outlined below can help you make an informed decision:  

Step #1: Assess Your Financial Health

Start by analyzing your budget, income stability, and existing debts. A clear understanding of your debt-to-income ratio is critical. If repayment of a subprime loan would stretch your finances uncomfortably or worsen your debt situation, it might not be the best choice.

Understanding Debt-to-Income Ratio (DTI)

In simple terms, your DTI is the percentage of your monthly income which will be used to pay off debt. 

For a subprime loan, a DTI below 36% (including the new loan payment) is generally recommended to ensure you can meet monthly obligations comfortably. A DTI above 43% is often a red flag for financial strain that will make repayment difficult.

Step #2: Be Clear on Loan Terms & Conditions

Review the interest rates, fees, and repayment period associated with the loan. Subprime loans often include high annual percentage rates (APRs) and upfront costs. Be vigilant for hidden charges or variable-rate terms that could escalate payments over time.

Here are some examples of rates and fees to look out for:

Origination fees

This is often a “hidden charge” that can range from 1% to 5% of the loan amount, charged upfront. (This means that, for a loan of $10,000, the origination fee can range from $100 to as much as $500.)

Payment processing fees

This is another example of a “hidden charge” to watch out for – there are often extra charges for certain payment methods, like paying over a phone app or dropping off a cash payment.

Prepayment penalties

Many lenders charge extra fees for paying off the loan early, which can significantly increase the total repayment amount (and also discourage the borrower from trying to get out of debt as quickly as possible).

Teaser rates

Subprime borrowers often have to deal with variable-rate loans that increase their repayment pressures. One example is an attractively low introductory repayment rate that is used as a teaser (or a lure), but that spikes after a few months to an unsustainable level.

Index-linked rates

Another variable-rate example is a rate that is tied to an index (for example, LIBOR or SOFR—these are global ‘loan repayment benchmarks' that fluctuate with the market), causing unpredictability in the monthly repayment amount (and in turn aggravating stress).

Practical Tip: Always use a loan calculator or seek professional advice to project total costs and repayment affordability under various scenarios. Understanding these nuances will help you decide if a subprime loan supports your financial goals or adds undue risk.

Step #3: Explore Alternatives

Before committing, investigate options like secured credit cards, peer-to-peer lending, nonprofit credit counseling (see section below).

Step #4: Evaluate Your Goals

Consider whether the loan will meet an essential financial need, such as purchasing a home or consolidating debt. Taking out a subprime loan for discretionary spending such as a lifestyle upgrade (better car, bathroom remodeling) is typically a poor decision.

Alternatives to Subprime Loans

If you're struggling to meet monthly obligations, it is worthwhile researching options besides subprime loans that may offer more affordable and sustainable relief compared to a subprime loan. Here are the most viable and widely recommended alternatives:

FHA and SBA Loans

• Federal Housing Administration (FHA) loans

Ideal for first-time homebuyers with lower credit scores. These loans feature lower down payments and more flexible qualification criteria than traditional mortgages.  

• Small Business Administration (SBA) loans

Provide affordable financing for entrepreneurs with credit challenges. Backed by the government, these loans offer competitive terms for business growth.

Loan Consolidation

Combining multiple debts into one loan with a lower interest rate can make payments more manageable. Balance transfer credit cards or consolidation loans from credit unions can reduce monthly expenses.

Secured Credit Cards

These cards require a deposit and help build credit responsibly with minimal risk. They are often more cost-effective than unsecured subprime credit cards.

Nonprofit Debt-Relief Programs

Organizations like the National Foundation for Credit Counseling (NFCC) offer debt management plans and free advice to help restructure your finances. For a more in-depth resource on obtaining debt relief, check out this helpful blog.

Peer-to-Peer or Family Loans

Borrowing from family or through platforms like LendingClub can be a low-cost option, provided repayment terms are clear.

Next Steps

You now have a much clearer understanding of the financial metrics and common challenges associated with subprime loans and their repayment. 

With this fresh insight, you're in a much better position to determine whether a subprime loan is the right choice for your current and long-term financial health. 

If you'd like to understand more about the basics of investment that can set you on the road to building wealth and prosperity, book a personal coaching call with veteran personal finance expert Joe DiSanto.