Many would say it is a loan designed for people with bad credit, so the title Sub-Prime. They would only be partially right. The answer to the question "what is a subprime loan" is a loan that the government sponsored agencies will not insure or purchase. Conventional mortgages have a strict set of guidelines that must be followed in order to reduce the risk to the lender and allow them to hand out the best rates. When your mortgage falls outside of these guides it is deemed a "subprime loan" or non-conforming loan.
Years ago, at the end of World War II, banks would lend money for your home on a hand shake and a promise. The problem was the common man had a shaky hand shake and did not usually qualify to buy a home without he had 20% down. America "hangs it's hat" on home ownership, many say it is the backbone of our country. In order to promote home ownership the government created agencies to insure or purchase higher risk loans from America's banks. This was the birth of FHA, Fannie Mae, Freddie Mac and a few other agencies designed to promote home ownership. Pretty soon banks were putting baby boomers in homes in rapid fashion.
Getting back to the question, "what is a subprime loan", banks soon relinquished their strangle hold on mortgages with the advent of "agency loans." Mortgage companies and brokers sprang up overnight to mitigate mortgages that were bought or insured by the government. However these companies still had the task of getting all of their customers to conform to the government guidelines. This newly formed mortgage industry soon realized that a large portion of would-be home buyers would never be able to conform to the guidelines set forth by the government agencies. Competition among this new breed of lenders spawned a new segment within the mortgage industry called the subprime lender.
So, what is a subprime loan? It is a product that a bank or mortgage company will offer to borrowers who fall outside of the government agencies guidelines. This type of mortgage company will charge a higher interest rate for this service. They loan money at an interest rate that is usually 2 to 5 points above the industry norm, but offer mortgages to people who would otherwise be unable to obtain one. Charging the excess fees and rates allows subprime lenders to compensate for the higher default rate that is associated with this type of lending. It also makes creates a very large profit for everyone involved in the subprime mortgage process.
A subprime loan can create opportunities for many borrowers other than those with poor credit. They help self employed borrowers that are unable to prove their income due to tax writ-offs. They also help borrowers that have less than the required down payment or that need to borrow money against their equity that is higher than agency standards. Agency loans charge mortgage insurance, (MI, PMI) on mortgages that exceeded 80% of the value of the home. Most subprime loans do not charge mortgage insurance on their loans, sometimes making a subprime loan more attractive than a "conforming" mortgage. Simply put, subprime lenders fill specific niches in the mortgage industry that government loans fail to reach. After a few bad apples, subprime lenders are essential to the overall health of the mortgage industry offering services to people who otherwise would have no one to turn to.