Q: Are long-term auto loans a bad idea?
A: It depends on who you ask.
If you ask borrowers, they can certainly rationalize why long-term loans are good. If you ask seasoned lenders and financial analysts, they’ll be more likely to point out the risks.
There’s no doubt the industry is seeing an increase in loan term length. The average new auto loan in Q2 2018 exceeded 68 months; the average used car loan almost 63 months, and more than one-third of new car loans exceeded 72 months, according to Experian data cited by US News and World Report. By the way, US News and World report thinks long-term auto loans are a bad idea.
Long-term auto loans aren’t unique to the US. CBC News reports that Canadians are five times more likely to take out a long-term loan than Americans. At one point in 2018, more than half of Canadian new-car loans were financed for 84 months. The average used to be 60.
What Drives Long-Term Auto Loans?
Several factors drive this trend:
- Strengthening economy;
- Historically-low unemployment;
- Low interest rates (if you’re prime or better);
- Burdensome student loans (no funds for a big down payment); and
- Increasing consumer confidence.
Increasing consumer confidence can motivate consumers to assume greater debt (not just auto) with a minimum downpayment. A new or used auto with a minimum down payment and low monthly payments will end up costing consumers more. However, for many, the appeal of acquiring a fine new vehicle with a minimum initial investment is hard to resist.
Weighing Opportunity Against Risk
For lenders, long-term auto loans are tied to higher interest rates, the promise of greater profits, and greater risk. With the growing preference for long-term loans, lenders can’t afford to pass up the opportunity: A healthy 6- to 7-year loan is more profitable and easier to manage than two 3-year loans. The challenge is accurately identifying and capturing those loans while minimizing the risk of delinquencies, defaults, negative equity, and even fraud.
The wealth of consumer data available today allows lenders to have more confidence in lending decisions. Multiple sources of consumer data paint a more detailed picture of an applicant’s financial position, helping to reduce the risk. Let’s examine a few long-term (72 months) auto loan scenarios to see how data is used to better gauge risk.
Credit Scores, Trended Credit Data, and Alternative Credit Data
When an applicant has a prime or superprime credit score, you might be quite safe in making lending decisions solely on the basis of the score, though one might question why someone with a good score and good income would request a long-term auto loan. Nonetheless, with those borrower attributes and an appropriate rate, a long-term auto loan is low risk.
When credit scores are in the good or lower tiers, lenders benefit by using additional data sources to accurately gauge the applicant’s financial strength. Trended credit data can provide as many as 30 months of credit card payment information. With that level of detail, lenders gain insight into a consumer’s ability to manage credit card debt.
A consumer who has demonstrated a consistent ability to pay the full monthly amount for the previous 24 months is a lower risk than a consumer who only pays the minimum while their
monthly payments increase. Information like that also gives a clue as to why the long-term loan is being requested; in some cases, a relatively modest long-term monthly payment is manageable. In others, additional debt is unsustainable.
If an applicant has a thin or non-existent credit history, as with newly-minted college graduates, and there’s no co-signer, a lender can use alternative credit data services to assess the applicant’s financial position. Alternative data include:
- Rent, utility, mobile phone and cable payments;
- Address history;
- Payday loans; and
- Public records that provide evidence of financial behavior.
Data that show a history of consistent and responsible payments boost a lender’s confidence in structuring a long-term auto loan. Data that show inconsistencies, late payments, or frequent changes of address are clear signs that a long-term loan would only add to the borrower’s financial stress.
A Front for Fraud
There’s one more note of caution to consider regarding long-term auto loans. With a minimum downpayment and false identity, a 72-month loan application can be the easiest method for an unscrupulous individual or a cartel to fraudulently acquire a vehicle. Lenders should consider the benefit of fraud analytics, as well as income and employment verification services to reduce to risk of loan fraud.
Not a Bad Idea If You Have the Right Data
Are long-term auto loans a bad idea? Not if lenders take advantage of the appropriate consumer data sources to carefully qualify applicants and structure deals based on borrower attributes. With the right data, lenders can take advantage of the long-term loan trend, making data-driven lending decisions to minimize the inherent risk of long-term auto loans.
defi SOLUTIONS‘ loan origination software experts welcome the opportunity to help you reduce long-term auto loan risk. Take the first step toward data-driven lending decisions by contacting our team today or registering for a demo of defi LOS.
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