The rapid growth in subprime auto lending has been making headlines recently. Total auto loan volume is close to $1 trillion, and 20% of that is being made to subprime borrowers. $27 billion of bonds backed by subprime loans were issued in 2015, compared to just under $9 billion in 2010. Even within the subprime market, the loans have become even more subprime. In 2011, 12% of securitized loans went to people with credit scores below 550. In 2015, 30% had scores below 550.
And now the delinquency and losses are starting to accelerate. According to Fitch, delinquencies on subprime auto bonds have hit historic records. 5.16% of borrowers are at least 60 days delinquent, which is the highest level since 1996. Losses have reached 9.74% as of February, an increase of 34% year-over-year. Even worse, these are delinquency and loss rates in a rapidly growing portfolio. These numbers will only get worse.
MagnifyMoney conducted a national survey (with Google Consumer Surveys*) and found that:
- 64.4% of auto loan borrowers let the dealer find them a loan
- 52.1% of auto loan borrowers never had their income verified
- 82.6% of auto loan borrowers who took out a loan with a term longer than 5 years did so to lower their monthly payment
- 17.4% of auto loan borrowers who took out a loan with a term longer than 5 years did so because “it was the dealer’s idea”
- Only 34.9% of borrowers shopped online for a lower interest rate before walking onto the dealer’s lot
These are troubling findings. MagnifyMoney believes that many of the bad underwriting practices of the subprime mortgage crisis can be found in the subprime auto sector.
As a reminder, here are some of the critical elements of the subprime mortgage crisis:
- Mortgage brokers received very high commissions for booked loans, but had no “skin in the game.” The brokers had a high incentive to book as many loans as possible, regardless of the credit risk.
- Banks and mortgage companies compete for brokers’ business. That means they try to make booking a mortgage as easy as possible, by reducing verification requirements, loosening credit requirements and increasing commissions.
- Banks and mortgage companies did not verify much information (often including income), which increased the risk of brokers committing fraud.
- Banks and mortgage companies created increasingly complex products. The main purpose: reduce the monthly payment as much as possible to get people into bigger and bigger loans.
The MagnifyMoney survey indicate that many elements of the subprime mortgage crisis are evident in today’s auto lending market:
- Dealers have potentially replaced the role of broker. Auto dealerships make money when they sell cars, and they make commissions (called “dealer discounts”) when they sell auto financing. Dealers, and in particular the people selling the finance products, have limited “skin in the game” if borrowers default. In many ways, dealers have the same financial incentives as the subprime mortgage brokers.
- Auto finance companies are competing to get the dealer’s business. As a result, they are often compelled to reduce the credit criteria and relax verification. The dealer networks, which control the customer and the volume, have a lot of power of banks and finance companies hungry for volume. If a bank asks too many questions, the dealer can easily move to the next easiest lender.
- Down payment requirements have been reducing. And, in the MagnifyMoney survey, we see that income verification requirements have also been reducing significantly.
- To help reduce monthly payments and increase loan amounts, banks have been offering longer terms. It is now relatively easy to take out a used auto loan with a 7-year term.
The Challenge with 7 Year Loans
Extending the term on an automobile loan, especially for used cars, can be dangerous. The car loan will lose value much faster than the loan will be paid off. The concern for subprime borrowers is that the used car will break down and the borrower will be upside down (which means they will owe more money than the value of the car).
On a 7-year loan, only about 25% of the principal balance will be paid off after two years of payments. According to Edmunds, a new car loses up to 25% of its value every year. Borrowers, especially with low down payments, will likely owe much more than the value of their car during a meaningful portion of the car ownership cycle.
What Should Consumer Do?
Here are thoughts from MagnifyMoney Co-Founder Nick Clements:
“Lending bubbles usually look the same. Credit criteria is loosened. Verification standards are relaxed. The people selling the loans make money when the loans are booked, but do not suffer from losses when the loans go bad. Consumers focus on the monthly payment, rather the economics of the deal. And we convince ourselves that it will be different this time. Almost all of those elements are present in the current subprime auto lending market. Some players are clearly worse than others. And as delinquency and losses increase, which they inevitably will do, we will discover which companies have remained prudent, and which companies have been irresponsible.
But our main focus at MagnifyMoney is on the consumer. And consumers need to shop around for better financing deals before they visit the car lot. They should keep the term on their loans as short as possible, because automobiles depreciate rapidly in value. And sometimes they just might have to buy a cheaper car.”
* MagnifyMoney partnered with Google Consumer Surveys to conduct a national survey of 673 individuals who own an automobile. Participants were at least 18 years old and resided in the United States at the time of the survey.