Will Increased Subprime Auto Lending Result in Another Financial Crisis?

For the first time since the financial crisis, people with a credit score below 680 are able to get their hands on new car loans again. Some are even obtaining loans for larger amounts than in previous years. While it’s great that individuals in need have access to reliable vehicles again, some concern has been expressed over the possibility of more loan defaults as a result of the increased leniency in borrowing standards.

Is it possible that loosening up too much result in more people taking on debt they can’t handle? Could giving people with lower credit scores access to a subprime loan cause more problems than it fixes?

When Subprime Auto Loans Dissolved and Credit Scores Suffered

No one can forget the devastation of the 2008 financial crisis. As companies went bankrupt in droves, millions of Americans found themselves unemployed and defaulting on loans at alarming rates.

Major auto manufacturers suffered greatly during this time as well. General Motors filed for bankruptcy, and while it was able to develop a restructuring plan to stay in business, it was forced to eliminate several popular lines, including Pontiac, Saturn and Hummer.

With so many auto manufacturers and financial institutions falling apart, many had to restructure their businesses to protect their assets as GM did. As a result, they tightened their lending practices, only providing loans to those with prime credit.

The only problem was with so many workers becoming unemployed and falling behind in their bills, credit scores nationwide dropped rapidly. In fact, in the summer of 2010, FICO Inc. revealed 25 percent of consumers had subprime credit scores, which equals nearly 44 million Americans with credit scores of 599 or lower.

With lenders making it more difficult to acquire a subprime auto loan for new cars, many borrowers had to turn to used cars. A June 2009 report from Experian Automotive found that used vehicle loans accounted for 68.13 percent of all automotive loans in the first quarter of that year.

Lending Improves with the Economy

Over the next year, the economy began to improve slightly. Though businesses had not totally recovered, many bounced back and as a result, increased their lending practices.

General Motors is one of the companies able to regain profits after its bankruptcy. One of the ways it did so was by getting back into lending, specifically the subprime business. After struggling to convince Ally Financial Inc.–which had taken control of its financing business after the bankruptcy–that it should get back into subprime lending, GM acquired AmeriCredit Corp. and began presenting car financing options to subprime borrowers.

Many financial institutions associated with auto manufacturers have decided to redistribute the bad credit auto loan. According to a Dec. 2010 report from Experian, the percentage of loans going to subprime buyers rose 8 percent in the third quarter.

So while 63 percent of all auto loans went to buyers with prime credit scores of 680 or above, more than in previous months went to people with no-so-great credit.

But that’s not all. According to the report, the average dollar amount financed for new cars increased to $25,273, which represented a $2,530 increase over third quarter of the year prior.

Financial institutions are feeling better about giving out money to individuals with a greater risk of default (partially to benefit from the increased money they can receive from bad credit auto loan rates), but is handing out these loans to subprime lenders a good idea?

Is Subprime Auto Lending Really the Way to Go?

One of the contributing factors in the financial crisis was financial institutions were handing out loans to people who did not qualify for them. This was a major problem in the housing market and a threat in the auto industry.

So now that auto lenders are willing to give out more loans in the midst of an improved, but still tough economy (the unemployment rate still sits at 9.1 percent), some wonder whether distributing these loans will result in the rampant defaults we saw in 2008 and 2009.

According to a recent report from the American Bankers Association, auto loan defaults had increased from to 1.74 percent from 1.67 percent in the third quarter. This means borrowers are having trouble paying off their auto loans, but not to the extent that they did after the crisis when the delinquency rate was up 9 percent.

And of course, while there is an increased number of Americans with low credit scores, many of those individuals are responsible borrowers who simply did not have enough money to pay their bills after losing their jobs.

Reports have already shown that lenders have stricter guidelines when it comes to the percentage of income they will allow for an auto loan. If lenders take time to ensure borrowers are fully capable of repaying the loans they’re being granted, then allowing subprime borrowers to have new auto loans in this still-tough economy may not be such a bad thing.