You know the terms. Most simply, they mean a borrower is seen as a higher risk and qualifies for a higher interest rate on their loan. Of course, either classification is based on their FICO or other bureau credit scores, which paint only a partial picture of a financial situation.
After more than a year of pandemic challenges, this group could grow, much through no fault of their own. How can your financial institution maintain responsible lending policies while also serving your community?
This article has their well-being (and savings) in mind. Here’s what we plan to cover:
- Difference between subprime and near prime and how that affects delinquency risk as well as interest rates
- The market, or, how many people fall into these categories. In other words, the opportunity.
- Current methods to reduce risk on these loans, as well as the pros/cons of each approach
- Any regulatory changes which may impact this kind of lending
- A possible solution that one credit union is doing to help empower borrowers
Ready to take a journey down the sub and near prime auto lending (we’ll leave mortgage for others more qualified there) reality? Let’s go!
What’s the difference between subprime and near prime?
Great question. Both categories help a lender define the risk level of the borrower and are ways to separate credit scores, with subprime being lower than near prime.
Subprime is used by auto lenders to describe potential borrowers which represent a higher-than-average risk of delinquency. Such individuals have a FICO range of 580-619. Near prime, also called a “fair” rating, have scores ranging between 620-659.
You may find the categories differ depending on the source. The previous scores came from the CFPB, while the myFICO platform defines “fair” as the entire range of above, incorporating subprime and near prime into one.
Some institutions do not offer loans to this group; where do you stand? We get there is a constant challenge to maintain a secure lending portfolio. However, as a mission-focused institution, it’s your responsibility to offer an affordable loan if able.
Up to 23% of American adults fall into this category, if you include deep subprime as well.
In a sense, it’s similar to the payday lender “competition”. These are the people you can help the most, and are often also those which are not able to open an account (or get approved for a loan), or, struggle to afford much higher rates and fees.
We believe offering loans to people in this category is an important aspect of financial empowerment. Of course, you need to adjust interest rates to account for increased risk. So long as they are still affordable and made with awareness of their financial situations.
Otherwise, these people will find somewhere else to get a loan (because they still need a vehicle), and the terms/rates may not be as reasonable. Plus, economic conditions hit them harder than those with more financial “liquidity”.
As an example, prime borrowers (FICO scores of 661 to 779) paid an average interest rate of 6.05% in the second quarter of 2020 on used cars. That was down 49 basis points from a year earlier. For subprime (using the 500-600 score range), their average was 17.78%.
Besides being far higher, it also increased year over year, up 42 basis points.
Near Prime Borrowing
This group is often served by community financial institutions. Near prime usually includes people with scores between 620-659, and makes up 8% of American adults. While they can often get loans, certain protections may need implementing at your financial institution.
These also enable lending to subprime borrowers. We’ll discuss two of those options below.
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The Subprime & Near Prime Auto Lending Market
Today in America, about 34% of auto purchasers are considered sub-or near prime. Yes, that number is from 2018, but 2020 FICO score data remains consistent. Throughout 2020, many policies prevented impact on credit scores. Such protections have faded throughout 2021.
With the cost of funds at historic lows, the opportunity to assist those with low or no credit is quite alluring. The rate of auto loan delinquencies has only ticked up 3.5% over the previous year, but the $2 trillion CARES ACT stimulus had an impact on it. Moving forward, we will see real impacts as Federal assistance stopped.
With unemployment in a range of industries high during the ongoing COVID-19 pandemic, there is a tepid response from financial institutions towards the subprime market. And yet, it includes people in need of affordable lending, and credit unions are eager to lend.
The opportunity for growth is here. How can you control risk during uncertain times while still serving your community? Here are a couple suggestions.
Minimizing Lender Risk While Empowering Borrowers
Besides your underwriting and interest rate structure, there are two main tools which can also help you minimize lender risk: GPS devices and loan default insurance. Each has benefits and pitfalls which are important to consider if entering (or expanding) this area of lending.
Both allow the financial institution to “go deeper” into near and subprime scores, thereby expanding their ability to lend.
Global Positioning Satellite (GPS) Device
Auto lending terms are clear. If a borrower defaults on their payments, the lending institution has the right (subject to varying state laws) to repossess the vehicle. Of course, at your institution, it’s all about helping the borrower find a way to continue payments.
No compassionate lender wants to repossess a vehicle. However, if that becomes necessary, finding the car can be a challenge.
In the past, lenders would work with skip tracers specializing in vehicle recovery. Once found, they contact a “repo-man” (or woman) who sweeps in with a tow truck, often under the cover of darkness, and haul away the vehicle.
With GPS tech, that’s no longer necessary. With a GPS tracker embedded in the vehicle, it can be located anywhere in the world (so long as it isn’t in a tunnel). Having the transponder in the vehicle increases the chances of repossessing the collateral if necessary.
This offers the lender an opportunity to recover all, or at least a portion, of any outstanding debt. In other words, it reduces the risk of that loan.
Repossession is a last-resort option for lenders. Most work with the borrower to keep the vehicle in their hands along with an alternative payment plan. Some GPS devices and services can help simplify this process while encouraging borrowers to stay current.
Borrower Benefit or Privacy Intrusion?
Of course, a borrower might consider their lender having a real-time fix on their location an unacceptable invasion of privacy. Same with the ability to keep their vehicle from starting if they are delinquent on payments. That’s not an unreasonable perspective.
Yet it can be seen as a borrower benefit if positioned correctly.
First, if this is a path your institution wishes to consider, you must have clear policies on the use of location tracking and the “starter interrupt”. Second, the starter interrupt must have both remote reset and “emergency override” capabilities. Third, it can be a borrower perk.
The GPS system can have a dashboard component which alerts borrowers as a payment is coming due, then also once it is overdue. It also can clearly show when vehicle startup will be disabled. Note: None of these systems will ever shut off a vehicle already running.
That aspect can be used by the borrower as a supplement to their vehicle alarm system. In essence, you would need to enter a code to allow the vehicle to start.
Sidenote: As far as the location tracking goes, some institutions have policies to not use the function if the borrower remains current. Deciding on staff access to this highly sensitive feature is an important part of implementation.
The device is reset remotely when the borrower makes a payment or works out an acceptable arrangement with their lender. The timing of these alerts and functions can be set to comply with local state laws.
Cost of System
The cost of the GPS device(s) (there can be a few installed to prevent removal) is passed on to the borrower through the loan. It can be with a higher rate or increased loan amount. If your policies allow, increasing the loan term can help keep payments within their budget.
Of course, your institution must create a loan policy to ensure consistency and avoid discrimination.
Loan Default Insurance
The other method of sub & near prime auto loan risk reduction is through the use of loan default insurance. With this approach, your institution contracts with an insurer to recover up the amount of the loan’s outstanding balance in the event of a default.
Compared to a GPS system, loan default insurance is more customized and typically does not cover down into subprime. In order to determine premiums, the lender submits certain information to the insurer to evaluate each specific risk.
Much like with GPS solutions, that calculated premium is directly or indirectly borne by the borrower. That can again be done through loan term extensions, additional monthly payments, or adjusted interest rates.
The advantage of this approach is that it has no perceived privacy intrusions for the borrower. Additionally, some institutions we’ve talked to made a point that tracking their members wasn’t in their culture, and the whole “feel” of the GPS system came across poorly.
However, loan default insurance does not offer the borrower any additional security features, nor does the institution know the location for simplified recovery of the vehicle. Of course, with coverage up to the amount of the loan’s outstanding balance, it’s less important.
If either of these programs are in consideration at your institution, hold a frank discussion with your team, board, and staff on the merits.
The Consumer Financial Protection Bureau (CFPB) sets the rules for lenders. Created in 2011 in response to the Great Recession, it aimed to protect consumers against abuses related to credit cards, mortgages, and other financial products.
In other words, the CFPB was a counter to the “To Big To Fail” banks and Wall Street investment houses involved in the economic collapse.
However, between 2016 and 2020, much of the agency’s regulations (stemming from the Dodd–Frank Wall Street Reform and Consumer Protection Act) were reduced and big banks received exemptions with the passage of the Financial Choice Act.
During that administration, the focus left predatory lending and consumer issues and instead reduced various compliance issues for all institutions in the hopes of generating increased business.
As of 2021, the Biden Administration is shifting the CFPB back towards consumer protection. This includes predatory lending, which may have an effect on subprime and near prime regulations in the near future. It also incorporates DEI (Diversity, Equity, and Inclusion) considerations, since this is often heavily woven into existing policies.
How One Credit Union is Doing Auto Lending at any Credit Score
While we discussed two methods to help enable deeper lending standards, we did not include another approach pioneered by a credit union in Detroit. What did they do? Were they able to go deeper into subprime with a clever lending tool?
Nope. They ignored credit scores entirely and offered fair rates to members who qualified. One Detroit CU serves a city with the lowest average credit scores in the country. So, they understood this would not be a good gauge for their lending standards.
Instead, they offered a first-time car buyer loan at 8.99%, regardless of credit score. And it didn’t end there. If you were a student or completed a financial education course with their coaching team, you received a 1.00% rate discount.
What a program. So why did they ignore credit scores altogether? Turns out, there are people who slip through the credit cracks.
Helping Serve the Credit Invisible
Around 22% of American adults don’t have any credit score. This can be due to insufficient credit history or simply no credit at all. They’re known as “credit invisible”. That program from the Detroit credit union would help them as well.
Does your credit union have the ability to serve someone without any credit score? If they came to you asking for a loan, what would you recommend? Chances are, their only option is a Buy Here Pay Here lender with rates upward of 25% along with likely repossession.
Talk about encouraging downward financial spirals. You are the solution to such scenarios, right? One Detroit CU can help you do the most to serve your community. (And I love that their homepage exclaims, “Your path to financial empowerment”!)
Lending When It’s Not Easy
As credit availability tightens, near and subprime borrowers are likely to be the most negatively affected. Community banks and credit unions, already watching for increased delinquencies, must maintain their underwriting standards to keep their portfolios above water.
However, institutions like yours have a mission to do everything possible to serve the needs of their communities. The tools we discussed, as well as the program at One Detroit CU, could help empower people, fund the institution, and continue to minimize risk.
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