We heard a lot about “subprime” lending during the 2008 crisis, as foreclosures skyrocketed around the country. Today, a different kind of subprime lending is rearing its head and putting borrowers at risk. Bad credit car loans can put you behind the wheel, but they can also put you in serious financial trouble.
What Is A Subprime Car Loan?
“Subprime” refers to the creditworthiness of the borrower. “Prime” borrowers typically have high credit scores, steady income, and a history of on-time and in-full payments on their credit reports. Subprime borrowers, on the other hand, typically have low credit scores, low or unstable income, and a poor credit history.
In the past, many lenders simply refused to extend credit or offer loans to subprime borrowers because it was considered too risky. Borrowers with a rough credit history are more likely to default, and lenders didn’t want to have loans on their books that were likely to go unpaid. In recent years, however, an industry has grown up around car loans for people with bad credit.
If a lender offers a large number of subprime auto loans, it runs the risk that so many borrowers will default that the lender will become insolvent. However, lenders don’t have to hold on to those loans on their books. Instead, they sell them off to a variety of investors. Why are investors willing to buy these risky loans? Because they come with very high interest rates.
The interest rate on a loan is determined, in part, by the level of risk associated with the loan. Prime borrowers get low interest rates, because they’re not very risky. Subprime borrowers, on the other hand, have to pay much higher rates. The average interest rate for prime auto loans is just 2.7%, while the rate for subprime loans is a whopping 10.4%. So, investors will purchase a certain amount of subprime loans because they get the benefit of those higher rates from the borrowers that do pay.
What’s The Risk Of Bad Credit Car Loans For A Borrower?
Bad credit car loans can turn into a debt trap for borrowers. With high interest rates, longer terms, and lower car values, it’s easy to end up owing more than your car is worth.
High Interest Rates
First off, subprime borrowers get stuck with sky-high interest rates. That means you’re paying a lot more for the car over the life of the loan.
For example, say you borrow $5,000 to buy a car and you have 5 years to pay it back. With a 2.7% interest rate, your monthly payments will be about $90. You’ll pay a total of $5,400 over the course of the loan – $400 in interest.
Now, imagine you take out the same loan at 10.4% interest. Your monthly payments would be about $107. That’s a total of $6,420 over the life of the loan – nearly $1500 in interest.
Longer Loan Terms
Prime car loans typically have terms of 3-5 years. Subprime loans, on the other hand, have average terms of 6 years and some last as long as 7 or 8. That’s because a longer term makes the monthly payments lower and more manageable. With those high interest rates, however, a long term costs borrowers a lot of money.
If you borrow $5,000 at 2.7% with a 4-year term, your monthly payments will be about $110. You’ll pay a total of $5,280 over the life of the loan.
If you borrow $5,000 at 10.4% with a 7-year term, your monthly payments will be about $84. You’ll pay a total of $7,056 over the life of the loan.
Lower Car Values
You probably already know that cars only go down in value once you buy them. If you buy a new car or a high-quality used car and pay off your loan within a few years, however, your car will still be valuable enough to trade in. If you buy an older car, it’s not worth much in the first place. With a high interest, long term auto loan, you’re likely to end up “underwater” – you’ll owe more than the car is worth.
That’s a serious problem. It means you can’t trade it in for a new car. It also means that if you stop making payments and the car gets repossessed, it will sell for less than you owe and you’ll be responsible for paying the difference.
Subprime Car Borrowers Are In Trouble
At first, bad credit car loans seemed like a great way to help people who wouldn’t otherwise be able to buy cars. And that much is still true – subprime loans are often the only option for people with low credit scores. However, the loans are expensive and frequently end up underwater. Many people find that they can no longer make the payments or that it doesn’t make sense to keep paying for a car that isn’t worth anything and end up in default. That leads to repossession, which leads to borrowers still owing the lender the difference between what the car sold for and what they borrowed.
Recently, the number of subprime auto loan defaults has been steadily climbing. Earlier this year, defaults rose to the highest levels since 1996.
Getting A Car Loan
We depend on our cars to get us to work, doctor’s appointments, the grocery store, and school. When you have low credit, you may not have many options as far as car financing goes. So what can you do?
The best possible option is to work to improve your credit before seeking an auto loan. However, that process takes time. If you don’t have the time to work on your credit, make sure you do your homework before agreeing to a loan. Shop around a variety of lenders to make sure you’re getting the best possible interest rate and the shortest possible term – remember that you can negotiate all of those elements. Consider the value of the car and how much it’s likely to be worth at the end of the loan, as well.
If you’re struggling with your car loan, you have several options for dealing with the debt. First, you may be able to work with your lender and refinance it to get a lower interest rate. If that’s not an option, you may consider filing a bankruptcy. Bankruptcy will wipe our your personal liability for the auto loan, so you can surrender it without having to worry about paying back the difference between what the car sells for and what you owe.