Subprime. The mere word invokes fear, as if legions of delinquent borrowers will rise up in a destructive spasm and smite the entire U.S. economy. Again.
Subprime loans granted to borrowers who never should have qualified for a mortgage triggered the housing bust that started in 2006 and led to the worst recession since the 1930s. So it has been a matter of some concern that banks have ramped up auto lending to borrowers with subprime credit scores. Subprime auto lending “reminds me of what happened in mortgage-backed securities in the run-up to the crisis,” bank regulator Thomas Curry warned recently.
The real problem, however, isn’t likely to be an epidemic of defaults or a fresh crusade by the repo man. Instead, subprime car buyers – who account for about one-third of all new-car purchases, according to Experian -- may be committing to costly loans that will take longer than usual to pay back, preventing them from buying another car for many years. “It’s more of a concern for consumers,” John Mendel, executive vice president of American Honda, tells me in the video above. “They’ll have less equity. It will cost them more to trade.”
Some auto loans now stretch for 7 or even 8 years—double the typical term of an auto loan 20 years ago. And subprime borrowers have both the longest loans and the highest interest rates. The average loan for a subprime borrower—with a credit score between 501 and 600 -- comes with a 10.4% interest rate and lasts for 72 months, according to Experian. The average loan for a prime borrower, with a credit score between 661 and 780, comes with a mere 3.6% rate and lasts for 69 months. Super prime borrowers, with a credit score up to 850, pay an average of 2.7% for loans with a typical duration of 62 months.
Those high interest rates for subprime loans are one reason many analysts aren’t worried about them. There’s nothing wrong with loans to riskier borrowers, as long as the interest rate is high enough to cover the increased risk and the potential cost of defaults. One reason the housing bubble burst is that rates on subprime mortgages were too low to account for the risk, which lured buyers who wouldn’t have been able to afford the home had the rate been set at an appropriate level—typically higher. And some loans were outright fraudulent. As foreclosures mounted, the supply of homes soared and values plunged, making a dicey housing market even worse.
The expansion of subprime lending has been one factor fueling a booming car industry that could reach record sales levels this year, since it gives more people the financing needed to buy a car. The average credit score for a new-car loan rose during the recession, as banks shut out riskier borrowers (and auto sales plunged). But it has since fallen back to 711, Experian’s data shows, the same level it was at right before the recession began at the end of 2007.
While easier credit gooses sales, it may also be pushing car prices higher and boosting the financial commitment required to score a new set of wheels. Many buyers focus on the monthly payment rather than the length of the loan, and stretching out the loan is one way to lower the monthly payment. That also lets buyers finance a more expensive car than if they were paying back the loan in less time.
But longer loans could become a problem for the whole industry in 4 to 5 years, as car owners who might typically trade in their car for a new model find they still owe more than the car is worth. Unlike most homes, cars depreciate rapidly, which pushes out the point at which the owner has positive equity in the automobile. “The implications are they have less equity sooner, which means it will cost them more to get out, which means they’ll probably keep it,” Mendel says.
For now, however, subprime loans are boosting sales, not depressing them. And any good salesman would rather have a flawed sale today than a better one tomorrow. For the time being, subprime loans need not invoke terror.
Rick Newman’s latest book is Liberty for All: A Manifesto for Reclaiming Financial and Political Freedom. Follow him on Twitter: @rickjnewman.