The warning signs are evident: a growing reliance on new, unproven loan products; a sharp spike in early delinquencies; and the collapse of a few smaller subprime lenders. Is auto lending in 2018 beginning to resemble the housing market circa 2008? Perhaps, but there are important differences. The economy is stronger than it was 10 years ago; the collateral for auto loans is different, and the auto market — while large — is still only a fraction of the size of the residential loan market. With the potential of tariffs looming over the industry, these warning signs warrant some concern and raise the question: Are auto servicers ready to deal with increasing delinquencies if the economy falters?
The Impact of Long-Term Auto Loans
Over the past few years, lenders have relied on longer-term loan products to get more borrowers into new cars and trucks. As vehicle prices and interest rates have increased, the length of the average new loan has risen from 65.5 months in April 2013 to 69.2 months in April 2018, according to Edmunds.com. At the end of last year, the Consumer Financial Protection Bureau reported that long-term auto loans (i.e., those longer than 60 months), accounted for 42% of originations in 2017, up from 26% in 2009.
Long-term loans are typically larger and feature higher interest rates than short-term loans, and borrowers who select these loans tend to have lower than average income and credit scores. As prices increase, consumers take out longer loans to have smaller monthly payments. As of 2017, the average loan amount for a six-year loan is $25,300; the average for a seven-year loan is $32,200. Five-year loans remain substantially lower at $20,100. Moody’s recently reported that borrowers with long-term loans had an average credit score of 725, while borrowers with short-term loans had an average credit score of 760.
Not surprisingly, the rise in volume of long-term auto loans has been accompanied by an increase in defaults. According to Fitch Ratings, auto defaults reached 5.74% in February 2018 —exceeding mortgage crisis levels (5.04%). Because longer-term loans tend to enter default more often, it is likely that regulators will receive a corresponding increase in complaints from consumers as lenders and servicers engage in more debt collection activities. More consumer complaints could lead to increased scrutiny from federal and state regulators, increasing the risk for auto lenders and servicers.
Keeping Up With Compliance
If the auto finance market experiences a downturn similar to the housing market crash in 2008, the federal government and states will likely respond with new laws and regulations. History shows that regulators in such an environment will also place a high priority on enforcement of existing consumer protection laws, especially those related to the required notices sent before, during, and after repossession. Lenders and servicers need to be prepared with compliant borrower communication and should be ready to implement any regulatory changes quickly. Having a robust compliance program in place can save millions of dollars in fines and judgments.
Matt Isaacson is senior regulatory counsel at Covius, a provider of technology-enabled solutions to financial services companies.