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Subprime Borrowers Pay Hard for Auto Loans

Subprime Car Rising Price
Reports have shown that the auto financing industry has been actively participating in a practice that most other lenders would never consider in this economic climate: issuing money to subprime borrowers. This practice of approving car loans to bad credit borrowers has been, according to some experts and reports, a contributing factor to the auto lending industry’s post-recession success. But from a consumer’s standpoint, subprime car loans may not be the miraculous opportunities that borrowers are led to believe they are.

According to a recent Forbes article, subprime borrowers pay a ton of money for the opportunity to finance a vehicle. How much do they pay? About four times more than what the least-risky borrowers pay.

Subprime Vs. Prime Auto Financing

Experian announced that the riskiest of borrowers, those dubbed “deep subprime,” received used-car auto loans at 17.9 percent in the first quarter of 2012. Borrowers on the opposite end of the spectrum, the “super-prime,” secured car loans at 4.4 percent.

If both a super-prime borrower and a deep subprime borrower applied to finance the same vehicle worth $20,000, the super-prime borrower would shell out a total of $2,317 in interest for a five year auto loan. The deep subprime borrower, however, would pay a much steeper interest fee of $10,406.

Onlookers may see these figures and cry about the injustice of forcing those with poor credit scores—arguably the portion of our population that is least able to afford more expensive interest rates—to pay the four times as much money for the same auto loan as their more credit-worthy counterparts, but from a lenders standpoint, it makes sense.

The Lenders Logic

The lending industry exists and flourishes because of the mechanic of interest. Lenders lend money and receive repayment for that money plus a premium—in the form of interest—at a future date.

If lenders received repayment on every loan they lent, we would likely see a much lower interest rate on car loans than we do today because the risk of lending money would be eliminated and lenders would be in a perfectly profitable business.

But of course, that’s not how the real world works.

Instead, auto lenders have to work on a principal called “risk-based pricing.” Risk-based pricing is the theory of offering better opportunities to more “favorable” borrowers, while increasing the cost for “less-favorable” (also called subprime) borrowers. That’s why those with good credit receive the best rates: lenders have to worry less about seeing their money return. Conversely, because lenders have to worry about subprime borrowers repaying their car loans, lenders increase the premium for borrowing for those with bad credit.

Is this practice fair though?

Fairness is a tricky concept to play with when it comes to money. While it may seem harsh to require those with poor credit to pay more for money, it’s only logical from a lender’s standpoint. Outsiders need to ask themselves whether or not they’d be comfortable lending money at low rates to people who have defaulted on their past car loans. The sad truth is that lenders wouldn’t stay in business for long if they indiscriminately issued money to anybody looking to finance a vehicle without considering their clients’ financial histories.

If walking in the shoes of the lender isn’t convincing enough, consider the current health of the auto financing industry respective to other lending branches.

The housing industry collapsed because it indiscriminately lent to subprime borrowers.

But since auto loan lenders have begun delving into the subprime market, they’ve seen an increase of $3.5 billion in asset-backed security purchases from investors according to Standard & Poors, reported Forbes. That’s an enormous figure, and one that most would have thought utterly impossible given the state of our economy.

Additionally, Equifax said that in 2011 the auto financing industry saw the highest level of new car loan originations since before the economy collapsed in 2008. They’re certainly doing something right.

While the lender’s logic is sound and profit-inducing, it still doesn’t change the fact that subprime borrowers are forced to pay a ton of money for auto loans. But when considering the alternative—the inability to even qualify for vehicle financing—this arrangement will have to be tolerated for the time being.

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