Car Loans May Threaten the US Economy. Should We Be Worried?

August 28, 2020

As the US economy continues to recover in fits and starts from the shock of the pandemic, a ticking time bomb may be laying in wait to stall progress and potentially shoulder millions of American families with unsustainable debt: auto loans.

A record number of Americans are behind on loan payments, often owing more than the asset is worth and with the subprime borrowers market the hardest hit. If you are having flashbacks to the currents that drove the global financial crisis, you’d be forgiven. But how big of a problem is this? And how much risk is shouldered by current borrowers?

As of June, 2020 an unprecedented $1.34 trillion dollars is currently owed for US auto loans according to the quarterly household debt report from the NY Fed, with subprime borrowing tallying around 22% of total loans. That’s much higher than the $0.82 trillion for all credit card debt, and close to the $1.54 trillion dollars in outstanding student loan debt. 5% of total auto loan balances are 90+ days delinquent, a near record high, just shy of the 5.3% record set in 2010 in the aftermath of the recession. That totals up to nearly 7.8 million Americans behind on payments. Subprime borrowing for auto-loans stands at around 22% of total loans.

But here’s the thing: these numbers aren’t suddenly worrisome; they’ve been slowly trending this way for some time. And notably, there hasn’t been a spike in loan delinquencies so far during the COVID pandemic. The NY Fed report notes the likelihood of some of these loans in a state of forbearance at the behest of the lender, but it’s unclear how much longer that will last. A recent TransUnion report notes that over 7.2% of all auto-loan borrowers are currently enrolled in a financial hardship program, higher than for any other loan type. So Should we be worried for what comes next?

It’s hard to say with any degree of certainty, and much of it depends on the still-unknown outcome of congressional negotiations surrounding another round of economic stimulus. If the added unemployment benefits are not renewed, or a new round of fiscal stimulus checks fail to come through, it’s likely we’ll see a marked rise in loan delinquencies. And while it’s too soon to make dire predictions for wider economic fallout, it is worth reflecting on the toll for low-income borrowers.

Low income households are disproportionately unable to work from home during the shutdown, and thus more reliant on car transportation than higher income households. All this as subprime borrowers for cars are saddled with substantially higher interest rates, longer payment timelines, and significantly higher risk that a missed payment will result in repossession. Subprime borrowers (those with a credit score below 660) will often be set with double digit interest rates, often 15-20%, compared to 3-6% for credit prime purchasers. For a 60-month loan covering the average cost of a used car, that difference can result in a total cost that’s $5-10 thousand dollars more for low income borrowers.

Those are substantial expenses. When accounting for additional fees often placed on subprime loans in addition to the total interest paid, it truly is rather expensive to be poor. All while the risk of repossession remains high, negating any payments made thus far.

More can be done at the regulatory level to reduce these risks. The US Consumer Financial Protection Bureau does not currently require auto-loan lenders to consider the ability of borrowers to repay a loan as grounds for abusive lending. Moreover, the CFPB has been substantially less enthusiastic towards cracking down on predatory auto lending practices throughout the course of the Trump administration.

So how can risk be reduced in a way that puts consumers and the economy on firmer footing? Here is a case where financial literacy interventions for prospective car buyers may induce positive outcomes. According to a recent industry report by Experian, over 26% of loans for new cars in Q1 of 2020 were taken out by subprime borrowers. For many whose finances may be uncertain, the financial risks of borrowing money for a new versus used car never add up.

The role financial literacy plays in the decision-making and behavioral choices of car consumers is an understudied area. There is reason to believe that timely financial education interventions would have a positive impact on borrowers deciding on where to pursue financing, and what their total budget should be. Understanding the true cost of car ownership including monthly payments, asset depreciation, insurance, and total gas bills is a crucial skill for car owners of any level.

It is still unclear whether the country will soon be forced to come to terms with the substantial amount of auto loan debt in the economy as we continue to see unexpected changes due to the pandemic. However, for many families the economics are working against them, with loan terms saddling households with unsustainable levels of debt. The pandemic has made clear that lower income workers face disproportionate challenges. Regardless of the wider risks to the economy, enabling better outcomes for subprime borrowers for car loans is the right thing to do. It is worth investing more in finding solutions.

Nolan DiFrancesco, Global Thinking USA Research and Reporting Manager