If you thought sub-prime loans were a forgotten relic of the financial crisis and Great Recession, think again. This kind of loan — that enabled many low-income Americans to buy homes before the sub-prime market collapsed — has now resurfaced in the automobile market as sub-prime vehicle loans.
The volume of auto loans made to consumers with bad credit has risen more than 130 percent over the five years since the immediate aftermath of the financial crisis. Last year, about 25 percent of all auto loans were made to sub-prime borrowers, and the total volume of sub-prime auto loans in the U.S. exceeded $145 billion in the first quarter of this year, up 15 percent from a year earlier, reports Experian.
Some economists and pundits say that this surge in sub-prime auto lending is eerily similar to the explosion in sub-prime mortgages, whose collapse was a major cause of the financial crisis. Some of the biggest banks and private equity firms in the country are pouring money into sub-prime auto lenders and making billions of dollars available for these types of loans. In addition, many sub-prime auto loans are being bundled together and sold as complex securities to mutual funds, insurance companies and pension funds — just like sub-prime mortgages were.
What Exactly Are Sub-Prime Vehicle Loans?
Sub-prime vehicle loans are loans made to borrowers with low credit scores — typically 640 or lower — usually to buy used vehicles. They feature higher (sometimes much higher) interest rates and fees than traditional vehicle loans in order to compensate lenders for the additional risk of lending to such borrowers.
Right now, it appears that sub-prime vehicle loans are great for lenders and investors, many of whom are reaping steady profits and high returns. But are they good for consumers as well?
The answer depends largely on whom you ask. Most lenders and car dealers will point out that sub-prime auto loans enable many people with damaged credit to buy badly needed vehicles they might not be able to purchase under standard loan underwriting criteria. While the cost of a sub-prime vehicle loan is admittedly higher, it is a cost that many with poor credit are happy to pay in order to buy a much-needed vehicle, they note.
But some consumer watchdogs caution that some auto dealers and lenders are taking advantage of desperate and financially unsophisticated consumers with these sub-prime auto loans. For example, some are charging exorbitant interest rates and other add-on fees that can jack the total cost of the loan up to much more than the value of the vehicle itself.
An investigation conducted by The New York Times found that sub-prime vehicle loans may feature interest rates as high as 23 percent, as well as fees for mysterious add-on products like life insurance that buyers don’t understand. This can result in loan balances that are more than double the value of the vehicle being purchased. In addition, the investigation revealed that some auto dealers and lenders are submitting incorrect information on borrowers’ loan applications about their income levels and employment situations. As a result, some car buyers are receiving sub-prime vehicle loans they cannot possibly repay based on their current income and job prospects.
Worse yet, some dealers are practicing outright deception and fraud. One used-car salesman in New York who was recently indicted on grand larceny charges for defrauding buyers with refinancing schemes is alleged to have told customers that their double-digit interest rates would fall after they started making payments. Other dealers waited for hours to tell buyers whether they even qualified for a loan, the Times investigation found, which left buyers thinking the sub-prime loan was their only option for buying a vehicle.
Auto dealers were specifically exempted in the 2010 Dodd-Frank financial reform legislation that was passed in response to the financial crisis. As a result, they are not subject to direct oversight by the Consumer Financial Protection Bureau (CFPB), which was created by Dodd-Frank. Therefore, legislation to curb subprime lending abuses by car dealers is restricted to states. California, for example, has passed laws that tighten rules dictating how cars can be repossessed and requiring used car dealers to provide better disclosure to buyers.
Should You Consider a Sub-Prime Vehicle Loan?
If you currently have a low credit score but need to buy a vehicle, a sub-prime vehicle loan may be the only option you have. If so, make sure you comprehend all the terms of the loan and your obligations for repayment in full before signing any loan agreement, including any add-on products that you don’t fully understand.
For example, if you are trading-in your old vehicle, and still owe money on it, this loan balance will probably be added to your new sub-prime loan, possibly at a higher interest rate than you’re paying now. Moreover, if you are unable to make your loan payments and your vehicle is repossessed, the lender might be able to come after you for even more money if they cannot resell the car for enough money to cover your sub-prime loan.
Finally, make sure that you can afford the payments on your sub-prime vehicle loan. If the total loan payment is going to stretch your monthly budget to the limit (or beyond), then you are probably better off just saying “no” to the vehicle purchase and sub-prime loan.
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