Subprime Automobile Loans in America

It is amazing how interconnected the modern financial world is. The lack of financial discipline by people from a certain industry is capable of throwing the entire world into chaos. The subprime mortgage crisis of 2008 which created the Great Recession is a testament to that fact. In the aftermath of the subprime mortgage crisis, rules were created to prevent such a situation from arising again. There are many regulators and media personnel that are paying attention to shady mortgage practices. Any issues are quickly reported and sorted out.

However, the auto lending industry is different. There is virtually no oversight and regulation for the entire industry as of now. This is the reason why risky lending practises have flourished in the auto industry. The fact is that several risky loans have already been made and many of these loans have already started becoming delinquent. Many analysts fear that an automotive subprime crisis might be there in the making. In this article, we will have a closer look at the factors which may be responsible for bringing about a subprime automobile mortgage crisis.

The Number of People Affected By These Loans

The subprime car loan crisis is by no means a crisis that will only affect a small number of people. The number of delinquencies is rising every day. As per the latest statistics, more than 7 million people are likely to face a problem making their car payments in 2019! Now, since people tend to stay in families and if we assume that on an average, there are 2.5 people in every family. We come to the startling realization that this crisis is likely to affect almost 17 to 18 million people, i.e. 5% of the American population.

Car Loans Start Underwater

Since car loans are not regulated, a lot of shady practices are still present in the market. For instance, in the case of home loans, the federal government decides the maximum loan to value ratio. This means that if a home is worth $100, banks will only be allowed to loan out $80 against it. This is done to ensure that the borrowers also have some skin in the game.

However, this is not the case with car loans. In order to sell more and more cars, many companies are willing to offer as much as 125% loan to value. This means that if a vehicle costs $100, companies are willing to include costs such as title transfer and accessories and hence will lend as much as $125 against this car.

This is obviously against the principle of sound lending. The car loan is underwater as soon as it is made. If the borrower does not pay the first payment and the car has to be repossessed immediately, the lender stands to lose money! However, lenders are still making such loans since they donít expect to hold these loans on their books. These lenders are securitizing these loans and selling them to unwitting investors just like the subprime mortgages.

Car Loans Stay Underwater For Longer Duration

Not only do the car loans start underwater, but they also tend to stay underwater for a long period of time. This is because the average duration of car loans has increased from 48 months to 66 months. During the earlier months, the payments consist of most interest. Hence, the principal outstanding remains almost the same. At the same time, as the car is being used, its market value falls rapidly.

Hence, for a long period of time, the market value of the car remains significantly lower than the loan outstanding on the vehicle.

In other words, the loans remain underwater for longer. Hence, if there was no impact on the credit rating of the borrower, it would simply be more prudent to abandon the loan. There is a need for regulations which limits the tenure for which car loans can be made to ensure that the loans always remain above water and the borrowers do not have a financial incentive to default.

Dealer Overage

Dealer overage is one of the many shady practices which are followed at car dealerships across America. Most borrowers are unaware that the interest rate that they pay on their car loans are negotiable. Hence, if they buy a car from a dealer, they can still take finance from other sources.

Taking advantage of this lack of knowledge, car dealerships sell these individuals loans which are more expensive. For instance, they send the credit profile of the borrower to a lender. The lender agrees to give a loan at 5%. However, using pressure tactics, these dealerships convince the borrower to pay a higher interest rate, for instance, 8%. In such cases, dealers receive cash kickbacks from the lenders. These kickbacks are significant and in many cases are more than the profit that the dealer earns by selling the vehicle in the first place.

The only problem is that only subprime borrowers who are unable to get a car loan otherwise accept such loan terms. Hence in order to get maximum commissions, the dealerships are increasing the number of subprime loans in existence.

The bottom line is that Americans are buying more cars. However, they are only putting down as much money as they did before. Hence, they are financing a large part of these loans by increasing the tenure. Also, the loans are being given to subprime borrowers, and the resultant portfolio is being securitized.

❮❮   Previous Next   ❯❯

Authorship/Referencing - About the Author(s)

The article is Written and Reviewed by Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to and the content page url.

Corporate Finance