The hidden risks of subprime auto loans

Many of us have been in situations where our credit scores aren’t where we’d like them to be.

But your lower scores might not stop you from buying a car. That’s because some lenders offer auto loans to what’s known as “subprime” borrowers — people whose credit scores are within a certain range (defined as 580 to 619 by the Consumer Financial Protection Bureau).

To get you up to speed on subprime auto loans, we’ll cover some basics.

• What is a subprime auto loan?
• How does a subprime auto loan work?
• What are the hidden risks of a subprime auto loan?

What is a subprime auto loan?

A subprime auto loan is aimed at borrowers who have credit scores within a certain range, which can vary depending on the source. While the Consumer Financial Protection Bureau considers a subprime score to be between 580 and 619, credit bureau Experian considers subprime to be between 501 and 600.

The CFPB defines five levels of credit scores for people who take out an auto loan.

• Deep subprime (credit scores below 580)
• Subprime (credit scores of 580 to 619)
• Near prime (credit scores of 620 to 659)
• Prime (credit scores of 660 to 719)
• Super prime (credit scores of 720 or higher)

Subprime auto loans are sometimes even extended to people who have no credit scores at all.

The Federal Reserve Bank of Kansas City emphasizes that there’s actually no universal definition of a “subprime loan.” More often than not, the borrower’s credit scores define whether a loan is subprime. But even the loan’s interest rate or the specific lender can be used to identify a subprime loan.

How does a subprime auto loan work?

Someone taking out a subprime auto loan usually has lower credit scores or no credit scores at all, so a lender typically charges higher interest rates and fees. Why? Because these loans often have higher delinquency rates than loans made to car buyers with higher credit scores.

Keep in mind that because of the nature of subprime auto loans, you might be required to provide additional information to a lender when applying. This could include income or employment verification beyond what’s normally required, like supplying your pay stubs or tax returns.

What are the hidden risks of a subprime auto loan?

Before you sign a loan agreement, consider the potential costs of subprime lending.

High interest rates

First and foremost, a subprime auto loan typically comes with a higher APR than a conventional auto loan does. The APR, or annual percentage rate, is the interest rate of your loan expressed as a yearly rate.

The APR for an auto loan can include fees, like a fee for originating the loan. The APR gives you a sense of how much it’ll actually cost you to borrow money for a car.

For example, a borrower with a FICO® score of 720 to 850 might qualify for a fixed APR of 4.55% on a 60-month loan for a $20,000 new car. Meanwhile, someone with a FICO score of 590 to 619 might qualify for an APR of about 16% for the same loan.

That can make a big difference in the total amount of interest paid during the life of the loan, amounting to $6,794 more paid for the subprime borrower in this example.

Interest rates on subprime auto loans can be upward of 29%, according the Columbia Business Law Review. People with shaky employment situations, and whose employment is dependent on access to a car, are often vulnerable because of it and might not have as much power to negotiate on the loan’s interest rate and terms.

Extra fees

Aside from a higher APR, higher fees might also be attached to a subprime auto loan.

For example, potential car buyers may be hit with several fees, like the following:

• A processing, or origination, fee for taking out the loan
• A prepayment penalty for paying off the loan early
• A service contract for repairs or maintenance service

Risk of default and repossession

Subprime auto loans are often at a higher risk for default and repossession than prime or near-prime loans, according to data from the 2018 Urban Institute analysis of American Community Survey.

If a borrower secures a subprime auto loan with a hard-to-manage repayment plan, it’s likely the borrower will default on the loan and the car will be repossessed, according to a 2016 analysis published by the University of New Mexico law school.

You can default on a loan when you fail to make on-time payments. And a default on an auto loan could lead to repossession of your car, which provides subprime auto lenders with a way to potentially recoup their funds — by reselling your repossessed car.

In fact, some less-than-responsible dealerships will “churn” the same repossessed cars as many times as they can, according to the Center for Responsible Lending.

The harm of default and repossession extends beyond just the loss of the car. A study by Cornell and Rice universities showed that people are much more likely to declare bankruptcy following a repossession, and they face more difficulty in successfully applying for credit in the future than consumers who were behind on car payments but didn’t experience a repossession.

Bottom line

While subprime auto loans come with some hidden risks, there are steps you can take to help reduce those risks.

• Figure out how much car you can afford. See what kind of monthly payment you can fit into your budget before applying for a loan.
• Check your credit scores. These scores carry a lot of weight in determining your lending options, so knowing where your scores stand generally can give you an idea of what your options might be.
• Consider more than the monthly payment. Weigh the total cost of financing a car. Keep in mind that if you lengthen the term of your loan from, say, 48 months to 60 months, you’ll pay more interest.
• Look at all of the expenses of car ownership. This includes state taxes, title fees, insurance, maintenance and repairs.

Finally, keep in mind that the scores you see on Credit Karma may be different from what the lender will use when evaluating your application. You can always ask your lender what information they use while reviewing your application.