PERSONAL FINANCE: WHAT IS SUBPRIME?
February 4, 2008 by ren
Filed under Corporate Finance
With all the global concern and anxiety churned up by the collapse of the subprime market, it is important to understand from a personal point of view what the noise is all about. We are thus starting a series of posts on personal subprime loans.
While the spotlight is on mortgages, subprime refers to all kinds of loans and is a category of borrowers or loans in which a financial institution places accounts evaluated as having a greater than normal risk of making late payments or of being in default. A subprime borrower can be a corporation, a small business, or an individual. In this series of posts, we will be focusing on the individual subprime borrower or loan.
Getting a subprime rating depends on a credit score generated through a credit rating system. Most commonly used is the FICO (i.e., from Fair Isaac Corporation which provides financial institutions with credit rating models).
The credit score is based on a probability model which evaluates the risk of late payments and/or default.
The focus of the credit rating system is on two items (given weights of 50% to 70%): debt service record and total outstanding loans.
Debt Service Record – there are credit bureaus which track on-time payments, arrearages and defaults gathered from financial institutions (and to which financial institutions subscribe).
Loans Outstanding – obviously, the more loans & different types of loans you have (e.g., credit cards, mortgages, car loan, etc), the more risk attached to new loans.
The other items considered in the credit rating system are: credit information available (the more information available with regard to your credit standing and behavior, the more confident the financial institution in granting a loan), how often you have availed of loans (the number of times you have availed of loans is one indicator of cash flow problems and the attendant higher risk).
Credit scores range from 300 to 850, where the higher score denotes a better risk. A score below 600 is subprime.
Image from Microsoft Clipart
