Who will lend to people having low credit scores?

Because student loans provide repayment records for credit rating, and may also indicate their earning potential, student loan default can cause serious problems later in life as an individual wishes to make a substantial purchase on credit such as purchasing a vehicle or buying a house, since defaulters are likely to be classified as subprime, which means the loan may be refused or more difficult to arrange and certainly more expensive than for someone with a perfect repayment record. Although there is no single, standard definition, in the United States subprime loans are usually classified as those where the borrower has a FICO score below 640. The term was popularized by the media during the subprime mortgage crisis or "credit crunch" of 2007.

Those loans which do not meet Fannie Mae or Freddie Mac underwriting guidelines for prime mortgages are called "non-conforming" loans. A borrower with an outstanding record of repayment on time and in full will get what is called an A-paper loan. Borrowers with less-than-perfect credit 'scores' might be rated as meriting an A-minus, B-paper, C-paper or D-paper loan, with interest payments progressively increased for less reliable payers to allow the company to 'share the risk' of default equitably among all its borrowers.

The value of U.S. subprime mortgages was estimated at $1.3 trillion as of March 2007,5 with over 7.5 million first-lien subprime mortgages outstanding. The subprime mortgage crisis arose from 'bundling' American subprime and American regular mortgages which were traditionally isolated from, and sold in a separate market from prime loans. These 'bundles' of mixed (prime and subprime) mortgages were the basis asset-backed securities so the 'probable' rate of return looked superb (since subprime lenders pay higher premiums, and the loans were anyway secured against saleable real-estate, and so, theoretically 'could not fail').

Many mortgages had a low interest for the first year, and poorer buyers 'swapped' regularly at first, but finally such borrowers began to default in large numbers. The inflated house-price bubble burst, property valuations plummeted and the real rate of return on investment could not be estimated, and so confidence in these instruments collapsed, and all were considered to be almost worthless toxic assets, regardless of their actual composition or performance. To avoid high initial mortgage payments, many subprime borrowers took out adjustable-rate mortgages (or ARMs) that give them a lower initial interest rate.

But with potential annual adjustments of 2% or more per year, these loans can end up costing much more. So a $500,000 loan at a 4% interest rate for 30 years equates to a payment of about $2,400 a month.