"Subprime" seems to be a dirty word in the lending world—both in the media and in the minds and hearts of many Americans who weathered the storm of the 2007–2008 Great Recession. It's completely understandable when you consider the wreckage that American businesses and consumers were ultimately left with.
In a perfect storm scenario of the housing bubble bust, loss of wealth, and cutbacks on consumer spending and business investment, the U.S. lost 8.4 million jobs in 2008 and 2009, according to the Economic Policy Institute, and approximately $16.4 trillion in wealth.
Recently, there has been an increase in the subprime auto lending business, and there are mixed emotions about whether this is a good thing or a disaster in the making. While some feel that subprime lending—no matter the borrower's' situation—is too risky for a still-shaky economy, others believe that subprime auto loans give borrowers with an unstable credit history the opportunity to improve their financial situation. According to The National Bureau of Economic Research, it's the liquidity restraints and lower FICO scores of the subprime borrower that poses higher default risk for lenders. In their estimation, extending an additional $1,000 in credit (as opposed to requiring the borrower to put that $1,000 toward a down payment) increases the risk of default by 15%.
On the other hand, some analysts believe that since subprime lending only makes up 30% of overall auto loans—coupled with the propensity of borrowers to prioritize making their auto loan payments over other debt—default rates should remain low—0.71% as of November 2014. Furthermore, according to Equifax, while the subprime market is growing, it is hardly a "boom." Growth has been steady and controlled, with prime lending rates doubling those of the subprime market.
Can Financial Institutions Benefit From Subprime Auto Lending?
Obviously, there is an inherent risk when it comes to a type of lending with less stringent credit requirements, but then again, there is risk with any type of lending. A borrower could have an 800 credit score and a steady stream of income, yet tragedy could strike, they could lose their job, and just like that, they could experience delinquency problems.
A Hand Up
Instead of dismissing this genre of the auto loan world because of the tainted past of subprime lending, financial institutions have the opportunity to learn from history, and use these loans to help underserved consumers. Since the Great Recession, many Americans that suffered damage to their financial standing have since worked hard to rebuild their credit worthiness. Subprime auto loans can stand as a tool to further their efforts.
The Equifax study mentioned earlier in this article found that subprime auto loans served as a path to redemption for many borrowers. In fact, consumers who originated a subprime auto loan increased their credit score 62.5% more than individuals that did not take out an auto loan. Subprime auto loans can be used as a "hand-up" to borrowers who are trying to rebuild their financial standing and creditworthiness, ultimately, transitioning them into prime lending programs.
Compete with the Competition
Subprime auto lending also has the potential to give financial institutions the ability to compete with big banks, dealerships, and other lenders that have more stringent credit standards. Think of it this way: if a potential borrower with a less-than-perfect credit history needs a vehicle to get back and forth to work, but has had the door slammed shut in their face by lender after lender, you could be presented with a unique niche of customers with essentially nowhere else to turn. And, with you being the institution that helped them so dramatically in their time of need, they will likely be loyal for years to come.
Furthermore, consumers with subprime credit scores may be accustomed to purchasing cars from "buy-here-pay-here" lots that can charge interest rates upward of 25%, so financial institutions have an opportunity to significantly undercut those rates, while still earning a sizable profit.
Increase Interest Income
Because of the higher interest rates associated with subprime auto loans, they can be a significant interest income generator for financial institutions. In 2014, the Filene Research Institute and the National CU Foundation began a non-prime auto lending pilot project with 12 credit unions acting as "guinea pigs." On average, the participating credit unions were charging an interest rate of 11.63%, compared to the typical 3%–4% for prime auto loans. According to the NCUF, if credit unions wrote auto loans to members with a subprime score of less than 600, they could increase their market share by 15%! It would also be prudent to add that aside from interest income, there is an opportunity to cross-sell additional products to these new borrowers, some of whom may not have an existing relationship with a financial institution.
To close, I'll borrow a quote from The New York Times, “Subprime lending by its nature involves evaluating the creditworthiness and ability to repay of borrowers who may have had financial difficulties in the past, such as a bankruptcy, a foreclosure or difficulty in managing revolving credit,” Stephen Jones, vice president investor relations at GM Financial, said in a statement.
It's true, financial institutions must define their own risk tolerance level and be prudent and vigilant when evaluating potential borrowers—possibly taking the individual's personal circumstances into consideration. However, they can also be open to the idea of delving into an underserved market that could not only lead to an increased interest income, but perhaps more importantly, give a person the opportunity to improve their credit score and gain financial independence.