Over a third of Americans have a credit score that is considered less than prime. And that's bad news for borrowers who are looking to save money when they borrow money as credit lines extended to subprime borrowers frequently come with steep costs.
"The biggest issue with a subprime loan is usually the interest rate," Jim Triggs, president and CEO of nonprofit credit counseling agency Money Management International, Inc (MMI), tells Select.
Subprime borrowers have lower credit scores than prime borrowers, and financial institutions worry they'll be at higher risk of defaulting on their payments. As a result, banks typically charge subprime borrowers higher interest rates and sometimes additional fees.
"For example, subprime marketplace lenders (online personal loan lenders) can charge upwards of 30% for a personal loan," Triggs says, noting that consumers with low credit scores are often taken advantage of due to their financial circumstances. "Obtaining loans such as these could put struggling consumers into a much deeper hole than they were prior to obtaining the subprime loan."
There are steps subprime borrowers can take to protect themselves from subprime loans, including brushing up on their financial education and reading the fine print.
Knowing your credit score can help protect you
One of the best ways a consumer can protect themselves from high-risk loans and credit cards is by knowing their credit score.
There are five different categories of borrowers, ranging from deep subprime to super-prime. While credit scores range from 300 to 850, those who fall into the subprime or deep subprime categories have scores on the lower end of the spectrum.
The credit bureau Experian classifies subprime borrowers with FICO credit scores between 580 and 669. Meanwhile, the Consumer Financial Protection Bureau (CFPB) Consumer Credit Panel defines subprime borrowers as those with credit scores between 580 and 619. Deep subprime consumers have credit scores that fall below 580.
A GOBankingRates 2019 survey found that nearly 40% of Americans don't know their credit score. It's important to be aware of where your credit stands because it impacts the kinds of loans and credit cards you will qualify for.
According to Tiffany Aliche, a financial educator and founder of The Budgetnista, you should aim for a credit score above 700 and ideally above 750 to get the best interest rates.
"Be patient and do not purchase before being ready," Aliche tells CNBC Select. She advises that consumers really take a look at the different interest rates being offered. "Understand just how much money you'll pay out if you have a lower credit score."
There are many ways you can check your credit score for free, including using resources like CreditWise from Capital One, Chase Credit Journey and Discover Credit Scorecard. You don't have to be a cardholder to check your score using these sites. And having a low credit score isn't a life sentence — there are steps you can take to improve it.
Have a plan to repay your debts
On top of knowing your credit score, it also helps to be able to clearly show that you have the ability to repay a loan or line of credit extended to you. If you already have a credit card, make sure you pay all your monthly bills on time and, if possible, in full, so you can show lenders you have a healthy track record of timely payments.
And if you're looking for a credit building credit card, be sure to review the terms and conditions carefully. Some subprime cards can charge high fees alongside high interest rates. A better option is a secured credit card, like the Capital One Platinum Secured Credit Card (see rates and fees) and the Citi® Secured Mastercard®. You pay a security deposit upfront that acts as your credit limit. Once you use this card for a while, you can be upgraded to an unsecured card and get your deposit back.
Bottom line
Subprime loans can put you in a very difficult cycle to break: If you're struggling to repay high-interest debt, you're at risk for falling behind on your payments. And since your payment history is the most important factor in your credit score, missing payments can further damage your credit.
"One should avoid high-interest subprime auto or personal loans if they possibly can," says Triggs.
Alternatives to subprime loans include borrowing from friends or family, getting a co-signer to help you get a loan or credit card, or selling assets. In the meantime, work on improving your credit and building an emergency savings to help prevent the need for loans in the future.
