Sub prime loans don't have a good reputation these days with the world's current economic conditions blamed on their existence. For those who have a deeper knowledge of the issues, sub prime loans are not to blame, it is the financial organizations and their methods of dealing with these loans that has caused the problems.
What then is a sub prime loan. Prime by definition signifies first or best. When it comes to loans, prime signifies that the borrower is a good or prime credit risk. Sub prime loans therefore are those loans that are not good credit risks. To cover the extra risk, lenders are able to charge higher, sometimes, much higher interest rates.
Whilst most people look at sub prime loans in relation to home mortgages, they can be applied to car and business loans as well. It is the latter, sub prime business loans, that really caused much of the current financial problems.
Sub prime loans work by taking a number of factors into account. The first is a lender's ability to pay. If they can afford to make the repayments today, they are considered for a loan. If their credit history is impaired, rather than receiving a prime loan, they will be offered a sub prime loan at higher interest rates. The loan is also secured against the property (or business for a business loan). If the borrower should default the lender will hope they can recover what is owing from the liquidation of the property. Their profit comes in the form of higher interest rates and the fees associated with creating a loan.
Where things go wrong is when prices go down. When a lender is prepared to finance a home for 95% of it's value - with a 5% deposit from the borrower, the home owner is said to have 5% equity. Over time, as they make repayments, their equity grows whilst the lenders equity shrinks (the loan outstanding shrinks).
If that property drops in value, and the value is significant, it can affect the lender's business in several ways. In the past two years we have seen some property values drop by as much as 15-20%. The borrower will soon realize they no longer have any equity. The lender will be found to hold an interest on property that is worth much less than it's book value. If the lender has enough of these devalued loans, their overall financial position deteriorates leaving them with a mass of properties that are no longer worth the loans issued - at least on paper.
Lenders then find that their own financial position is weakened and they are forced to pay higher interest rates to attract borrowers - this then becomes a problem for them. Good lenders have always had balanced lending policies ensuring the greater proportion of their loans are in the secure prime mortgage loans.