Is another credit bubble forming in subprime car loans?

I went shopping for a new car last week and was offered a subprime loan rate that sounded too good to be true. Without even checking my credit history, I was offered the choice of nothing down & half of one percent financing for 5 years. If I wanted to pay cash for the $30,000 vehicle, the dealership would reduce the price by 2,500 dollars.

The credit manager took some time to explain how subprime loans work. Auto makers take their cash back amount and give it to the finance company to buy down the interest rate. So in my case, I could take the $2,500 cash back or it would go to the finance company to reduce my loan interest. My choice really didn’t affect the car dealer in any way.

It got me thinking about some of the articles that I read sounding the alarm bells on the rising delinquency rates in subprime auto loans. Much of the concern centers around loans extended to borrowers with credit scores below 600. Some articles warn that the auto-loan market is a powder keg like the subprime mortgage market was when the globe plunged into a financial crisis eight years ago.  Will the bursting of this bubble cause another U.S. recession?

John Oliver, host of the HBO show “Last Week Tonight,” takes on the opaque world of auto lending.

Oliver points out that while helping people buy a car sounds great, lenders are taking advantage of borrowers with some predatory strategies and absurdly high interest rates. Some are offering loans to those who have recently filed for bankruptcy. Poor borrowers charged high interest rates–the average rate is 19%– end up under a pile of debt. One clip showed that a woman would have to spend $17,000 paying back a loan for a car worth $3,000.

Auto loans, including the loans extended to prime and subprime borrowers, topped $1 trillion for the first time last year, according to Experian data, exceeding the outstanding balances on U.S. credit cards. But that is a far cry compared to the $8.4 trillion mortgage market. Plus, it’s easier to repossess a car than foreclose on a home. There is typically a healthy marketplace for used and repossessed cars. Trying to unload a $300,000 home is far more difficult especially in a neighborhood of foreclosed properties.

As an investor, be aware that massive defaults on auto loans could flood the used-car market, depressing prices for all car types should the bargains among used-vehicle options sway buyers away from new cars. Both Ford & GM are trading with low P/E’s (5.8 & 3.9) and have dividend yields in the 4.7% range. The yield is very attractive for investors looking for income as long as you understand that there could more downward pressure on the stock price.

In a quarterly filing with the Securities and Exchange Commission, Ford reported in the first half of this year it allowed $449 million for credit losses, a 34% increase from the first half of 2015. General Motors reported in a similar filing that it set aside $864 million for credit losses in that same period of 2016, up 14% from a year earlier.

If you are in the market for a new or used car, make sure that you can afford the payments. Don’t fall for, no money down ads, 100% approval rates and no sin number required. Remember a car starts to depreciate as soon as you drive it off the lot. Extending a car loan to 84 months (7 years) keeps your monthly payments low but the outstanding loan could be greater than the value of the actual car.

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2 thoughts on “Is another credit bubble forming in subprime car loans?

  1. There’s been a lot of buzz about this topic lately. I’m more worried about student loan defaults than auto loans, but both are concerning. Your point about investing in GM or Ford is a good one. This industry has a lot of external factors that determine the sales and stock performance of their stocks. Investors need to be comfortable with valuation swings before buying automotive stock.

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