The auto finance industry has veered away from in-person encounters amid the COVID-19 pandemic, but consumers remain the ultimate barometer of risk and repayment. So what will consumer credit characteristics look like in 2021?
The five C’s, as they are called, refer to the five main variables lenders analyze to gauge consumer creditworthiness: capital, capacity, character, collateral and conditions. Let’s look at the status of these factors and to assess their influence on originations in 2021.
Capital. For starters, lenders must determine whether potential car buyers have the cash available — via savings, investments or other assets — to repay their loans. Household income is the main source of repayment, but extra capital can indicate that consumers are skilled at saving money and managing finances, making them less of a credit risk.
Two indicators of capital availability are personal income and personal saving rate, both metrics that have declined in recent months. Personal income fell 1.1% to $221.8 billion in November 2020, according to the U.S. Bureau of Economic Analysis. The personal saving rate — equivalent to income less expenditures and taxes — fell to 12.9% in November. By comparison, the personal saving rate hit 33.7% in April last year.
Those declines in income and savings come as vehicle prices continue to climb. The average amount financed for new–vehicle purchases rose to $35,373 in the fourth quarter of 2020, up 5.5% from the prior year period, according to Edmunds. Similarly, average monthly payments increased to $581 in the fourth quarter, up 1.9% from the previous year.
- Outlook: Vehicle prices and financing are on the rise at a time when consumers’ income and savings are declining.
Capacity. The stability of consumers’ monthly income over an extended period of time is another important measure of repayment ability. To that end, lenders evaluate debt-to-income ratio (DTI), which compares the total amount of debt a consumer owes each month with the total amount earned. The higher the DTI, the greater the credit risk.
The unemployment rate — as a result of COVID-19 — has thrown a wrench into income stability. Though the rate held steady at 6.7% in November and December 2020, it was nearly double the 3.5% rate recorded in January and February 2020, according to the U.S. Bureau of Labor Statistics.
Meanwhile, the consumer component of the household debt service ratio, which measures the ratio of household debt payments to disposable income, clocked in 5.28% in the third quarter of 2020, according to the Federal Reserve Board. That rate was up from 5.09% in the second quarter, but lower than the 5.70% range that had prevailed since the second quarter of 2019.
- Outlook: A relatively high unemployment rate and rising debt-to-income ratios increase consumer riskiness for lenders.
Character. Also referred to as credit history, this metric illustrates consumers’ track records for managing credit and making payments over time. Solid payment history, low outstanding debt and few missed payments are positive indicators for lenders.
On this front, average consumer credit scores on both new and used vehicles have been showing steady increases since 2015, according to data from Experian. Along those lines, the ratio of subprime and deep-subprime customers continues to shrink.
- Outlook: Consumers are moving up the credit spectrum.
Collateral. Vehicle values help lenders determine risk in another way. The higher the value, the lower the chance the lender will lose money remarketing a repossessed vehicle at auction.
Collateral values have been steadily climbing for seven straight years, providing lenders with a remarketing cushion. Wholesale used–vehicle prices increased 14.2% year over year in December 2020, to 161.1, according to the Manheim Used Vehicle Value Index, and they’re up a whopping 30% since 2000. With inventory sitting at 17% below last year’s levels, per Cox Automotive, used- and new-vehicle prices are likely to remain elevated.
- Outlook: Strong vehicle values could soften the blow of higher repossessions.
Conditions. Interest rates influence the riskiness of auto loans, particularly in the context of the economy, industry trends and pending legislation.
Auto loan interest rates, for one, have been hovering in the low 4% range, according to Informa, and will likely remain at those levels until mid-2022 or early 2023. While low interest rates make it easier for consumers to purchase vehicles, they squeeze lenders’ profit margins.
Meanwhile, on the cusp of a new presidential administration, the industry will likely see a return to regulation by enforcement, along with greater emphasis on fair lending. GAP, debt–collection activities and consumer privacy will also be hot-button issues.
- Outlook: Though low interest rates may entice car-buying consumers, they will challenge financiers — particularly those in the prime sector — amid a tougher regulatory environment.
Consumer credit dynamics will be a mixed bag this year, prompting lenders to adjust underwriting parameters to accommodate risk appetites, and it’s possible that higher down-payment requirements and larger declines in loan-to-value ratios are on the horizon. Consumers will likely continue to press for extended loan terms, as they seek lower monthly payments and look to curb hiccups in their income.
Auto Finance Innovation Summit, the premier event for technology in auto finance, returns March 16-17, 2021, as a virtual experience. The virtual experience will offer the quality networking and education of past events, all through an online platform. To learn more about the 2021 event and register, visit www.AutoFinanceInnovation.com.