Over the past several years, there has been a sharp increase in the number of new auto loans, driven by a surge in lending to borrowers with poor credit. In 2015, the number of new subprime auto loans reached their highest level since before the financial crisis, surpassing subprime mortgage issuance in volume. While providing access to credit to subprime borrowers is essential for a healthy, functioning economy, it is also a risky business which should be conducted with extra care to protect both the borrower and the lender. Because their credit history is weaker, subprime borrowers often pay higher interest rates on loans due to the perception that they are more likely to miss payments during difficult economic times.
In recent years, Americans have been borrowing record amounts to purchase vehicles, which are among the most commonly held type of nonfinancial asset in the United States. Cars have become a necessity for many families who rely on them as their primary means of transportation and to access greater economic opportunities, including employment. For many, owning a car is seen as such a necessity that they will pay their monthly auto-loan payment before paying their mortgage.
According to Experian Automotive, the average loan for a new car in the fourth quarter of 2015 was $31,008 for prime borrowers and $28,231 for subprime borrowers, with the amounts to both types of borrowers increasing from the previous year. Typically, subprime borrowers tend to stretch the loan for a longer period to reduce monthly payments, increasing the total amount paid over the life of the loan. According to Experian, fourth-quarter 2015 auto loans with a term of 73 to 84 months accounted for 29% of new vehicle loans, with 71% of new car loans exceeding five years. Besides increasing the overall cost of the car, longer loans carry a higher risk of negative equity (when the loan balance exceeds the value of the vehicle) as cars typically lose 15-35% of their value in the first year and 50% or more over three years.
A sizable added cost for subprime borrowers is the dealer markup. When a borrower obtains a loan at a car dealership instead of a bank, the dealer can charge an additional fee for their services. Usually, loans to subprime borrowers have higher markups, which can produce a higher default rate. Federal officials have expressed concern over this practice, as the system incentivizes dealers to charge higher rates. There have also been cases of discriminatory lending practices. Ally Financial agreed to pay $98 million to settle Department of Justice and Consumer Financial Protection Bureau lawsuits that alleged it marked up interest rates on auto loans to minority borrowers.
Providing access to credit to subprime borrowers, especially the under-banked and unbanked, who encounter the most difficulties in obtaining any kind of access to credit is important for individuals, as well as our economy as a whole. At the same time, if companies do not lend in a responsible way, their lending may constitute harmful predatory lending. At Domini, we seek to invest in companies and securities that provide non-predatory access to capital for those historically underserved.