What is Sub Prime Lending?

Whenever any of the customer visits a bank asking for loan, every bank in India or abroad will ask for certain documents. These might vary from the type of loan to the various institutes. The main idea behind asking for documents is to ascertain the credibility of a customer from his/her credit card transactions or previous loan transactions and guess the background of customer’s financial capability. 

In India for example, if you try to get a home loan, you are asked your salary certificate and other loan details. This will indicate the capability of a customer to repay back the loan and also is an indicator of the amount of risk a bank is taking on that customer. The bank earn by charging interest rate on the loan.

The sub-prime lending came because there are lot of demand for loans in the market and the laws were less strict in terms of whom to give the loan. Hence banks started giving money to customers even with poor credit ratings. This implies that banks took more risk (knowing that the possibility of the repayment is less) as per the history of the customer. This is done, so that banks can charge customers higher interest rates and can get a huge profits. The idea is that even if few percent loans get defaulted, you still can recover the losses by charging those extremely high interests.

Subprime loans can offer an opportunity for borrowers with a less-than-ideal credit record to become a home owner. Borrowers may use this credit to purchase homes, or in the case of a cash-out refinance, finance other forms of spending such as purchasing a car, paying for living expenses, remodeling a home, or even paying down on a high interest credit card.

There was also a lot of fraud involved in this sub-prime lending. Since a bank can charge higher interest and administrative charges on a sub-prime lending, they even started giving such loans to borrowers who were well with their credit history.

Imagine if most of the borrowers start defaulting on the sub-prime loan taken. The lenders would suffer significantly and that is what happened. The financial complexity of how such simple thing can lead to the current US financial crisis is difficult to understand.