Depending on the health of your finances, your credit can be a passport or a padlock. It can grant you access to amazing new experiences and opportunities for growth, or it can keep you from achieving goals like buying a house or starting a business.
Consumers in the latter group are classified as having subprime credit. Here’s what that means for your finances – and how to change your credit situation for the better.
If you have subprime credit, it means your credit score falls below a certain threshold.
There are two main credit score models used by lenders:
FICO counts credit scores 669 and below as subprime, while VantageScore counts scores below 600 as subprime. If your credit score does not fall into the average credit score range and is slightly below, you may find it difficult to get approved for a conventional loan.
Since about 90% of lenders use FICO scores when evaluating borrowers, use your FICO score when determining if you have a prime or subprime credit score. Many of the free credit score sites out there typically show you your VantageScore.
Borrowers with subprime credit often have a default, bankruptcy or several late payments on their credit report, causing their poor credit. They may also have a high credit utilization ratio and multiple recent hard inquiries.
Lenders may deny a conventional loan or other lines of credit to subprime borrowers. If a subprime borrower is approved with their low credit score, they’ll likely be charged extremely high interest rates and other fees.
When you have subprime credit, lenders will charge higher than average interest rates when loaning money to you. You may also find it harder to be approved for loan products.
Utility, car insurance and telephone companies will also check your credit when you apply. If you have poor credit, you may be denied or have to put down a deposit as collateral.
If you work in finance, law enforcement or the military and are applying for a new job, a potential employer may check your credit during the application process. In this case, a subprime credit score could disqualify you from being hired.
Some financial products are targeted directly to people with subprime credit. Here’s a rundown of what a few major subprime lending products look like.
Subprime auto loans have higher interest rates and often charge prepayment penalties, which is a fee imposed on borrowers who repay their loan ahead of schedule.
Some subprime auto lenders engage in fraudulent lending practices, often inflating the value of the car so they can collect more money from the borrower.
Chances are, if you have a subprime car loan, you could be at greater risk for being “upside down” on your loan, meaning you owe more than the car is worth. (Learn more about upside down car loans).
A subprime mortgage almost always has a higher interest rate than a conventional mortgage loan. The interest rate on a subprime mortgage is usually adjustable, meaning it will increase if overall interest rates rise, according to the CFPB.
This can surprise borrowers expecting a stable payment structure.
A lender may offer you a subprime loan even if you qualify for a prime loan. For example, a subprime borrower with a 600 credit score may not qualify for a conventional mortgage, but they may qualify for an FHA mortgage.
Lenders who provide FHA loans require borrowers with a credit score between 500 and 579 to make a 10% down payment. Those with scores of 580 or above only have to put down a 3.5% payment.
If you want to buy a house with an FHA mortgage and have subprime credit, you’ll also have to go through financial counseling through the Department of Housing and Urban Development (HUD). This ensures that you understand how your mortgage works and are better equipped to handle the payments.
Borrowers with subprime credit usually won’t qualify for the most common credit cards, especially travel or cash back rewards cards.
For someone in this situation, the options are more limited to subprime credit cards with higher APRs and lower credit limits. These cards rarely have the rewards and benefits that come with regular credit cards.
Consumers with subprime credit do have the option of opening a secured credit card, which requires a deposit to act as collateral for the credit limit.
For example, a secured card with a $300 credit limit will require a $300 deposit. This way, the cardholder gets the opportunity to build a stable credit history at no risk to the lender.
After several months of on-time payments, you may be able to get your deposit returned. And your credit score will have improved significantly – if you used your card right.
Subprime credit could be improved by following a few basic rules:
Let’s break these down a little more.
First, pay your credit bills on time. Payment history is the most important factor and makes up 35% of your credit score. Set up autopay for your bills or use calendar reminders if you prefer paying manually.
Check your credit report regularly to catch errors or evidence of identity theft. According to the Federal Trade Commission, one in five people have a mistake on their credit report.
If you find a mistake, dispute it with each of the three credit bureaus. You can find your free credit report at AnnualCreditReport.com.
Those with negative items on their credit report need to be patient. The only way to remove a bankruptcy or default is to wait a certain amount of time, after which it will be removed from your credit report. This time period is usually between seven to 10 years.
The good news is that older bankruptcies and defaults impact your credit score less and less over time. A medical bill that went to collections five years ago has less impact than a bill that went to collections two years ago, for example.
Borrowers with credit cards should be aware of credit utilization, or how much of the total credit limit is being used.
You can calculate this yourself by dividing the current balance by the total credit limit. The maximum percentage a borrower should have is 30%, but lower is better. Try to have less than 10% utilization at all times.
If you don’t have a credit product right now, consider tools to build your credit, like a credit builder loan or secured credit card. These tools are designed for people with no credit or bad credit. By paying on time and keeping your card balance low, they could help you improve your credit over time.
Learn more ways to build your credit
Depending on the specifics of your credit report, it can take months or even years to move out of subprime credit status. But with some effort and patience it can be done.
Zina Kumok is a Financial Health Counselor and Credit Counselor, certified by the National Association of Certified Credit Counselors, who writes extensively about personal finance. See Zina on Linkedin and Twitter.