Subprime auto loans may be harder for dealerships to place with lenders

NASHVILLE, Tenn. — It's likely more difficult for a dealership to place a subprime auto loan with a financial institution than it was less than a year ago, a chief risk officer for a subprime lender explained at a conference last month.

But the type of vehicle being financed, the speed at which it delivers equity and the existence of a service contract can make a borrower a better credit risk, according to an executive for a large regional buy-here-pay-here dealership group.

These experts took part in a subprime lending forum at the Auto Finance Summit East conference on May 12, following a first-quarter decline in the percentage of credit-challenged subprime customers obtaining auto loans and leases.

"It is as hard as it's ever been to help somebody with special finance lenders," Jesse Powers, finance director for Oakes Kia in North Kansas City, Mo., told Automotive News on May 26.

According to Experian, subprime borrowers were involved in 14 percent of loans and leases written on new and used vehicles in the first quarter of 2023, down 1 point from a year earlier and 4 points from the largely COVID-unaffected first quarter of 2020. Deep subprime borrowers received 2 percent of first-quarter loans and leases, down from 2.3 percent a year earlier and 4.1 percent in the first quarter of 2020. Experian classifies credit scores of 501 to 600 as subprime and scores of 300 to 500 as deep subprime.

Experian said the proportion of subprime used-vehicle loans reached "near record lows" for the first quarter, with subprime debt making up 20 percent of them, down 2 points from 2022 and 5 points from the first quarter of 2020. New-vehicle subprime loans in the first quarter fell to 5.1 percent, down from 9.6 percent in 2020 and 5.4 percent in 2022.

Panelist Michael Opdahl, COO for Automotive Credit Corp., said demand for vehicles remains but the market has become more difficult for subprime borrowers. Automotive Credit captured fewer borrowers over the previous six months because of its own tightening and consumers' reduced creditworthiness, he said,

"What we're seeing now is some of the lowest FICO scores ... we've seen in years," Opdahl said. Consumers who might have qualified for loans in the past are "not even close," he added.

Jennifer Parsons, senior director of finance at Walser Automotive Group in Minnesota, said subprime deals aren't as common in her state, where residents tend to have higher credit scores. For the subprime deals her group does handle, no significant change in lender behavior was noted, she said.

"It doesn't feel like subprime is any harder to get done right now than it used to be," Parsons said.

Yet this sentiment might just reflect higher vehicle prices making subprime loans more challenging the past few years, she added. "Maybe I'm just used to it being a little tougher."

Walser Automotive, of Edina, Minn., ranks No. 28 on Automotive News' list of the top 150 dealership groups based in the U.S., with retail sales of 23,346 new vehicles in 2022.

Opdahl said that during the pandemic, consumers experienced credit "score inflation" from "stimmy funds" and the removal of certain items from their credit reports. A borrower had to be "pretty bad" not to grow their credit score in 2021 and 2022, he said.

Automotive Credit saw the consumer debt-to-income ratio grow "exponentially" starting in April 2022, Opdahl said. Subprime customers ceased receiving stimulus funds and were "getting punched in the stomach" with factors such as inflation and gas prices. They began to rely on their credit cards to make do, he said.

The company observed FICO scores fall 40 points between September and the end of 2022. "Thankfully," they leveled off in the first quarter, Opdahl said, before dipping again in April.

Subprime borrowers are the reason two-month auto loan delinquencies rose from 1.43 percent in the first quarter of 2022 to 1.69 percent in the first quarter of this year — higher than in the recession of the late 2000s, according to an S&P Global Mobility analysis of TransUnion data.

The data indicates borrowers who took out used-car loans in the first half of 2022 were more likely to be late on their payments than used-car buyers who borrowed in the first six months of other recent years, S&P Global said. But lenders took action to address the issue, and consumers who borrowed in the second half of 2022 made their payments with a similar consistency as their peers in other years, it added.

Auto Finance Summit East panelist Scott Fontaine, chief risk officer for Flagship Credit Acceptance, said internal models throughout the industry did not anticipate the impact of inflation, focusing instead on unemployment. Consequently, lenders found their portfolio of loans performing worse than expected, with delinquencies rising almost in lockstep with inflation increases.

Fontaine said inflation forced customers to choose between buying eggs and making a car payment.

"They chose eggs," he said.

Opdahl said Automotive Credit was also caught off-guard. It, too, failed to account for inflation. In the second quarter of 2022, "we really locked things down" after noticing a delinquency trend, he said.

Flagship toughened its underwriting in 2022 as well, according to Fontaine.

Powers said that vehicle prices and interest rates are pushing special finance customers out of the market.

"You used to be able to buy a car if you made $15 an hour," the "special finance guru" for Oakes Kia said. With that income today, "it can be very difficult to find a car that a bank will approve you on."

Placing a subprime deal is likely harder for a dealership today than it was nine months ago, Fontaine said.

Dealerships tend to know their partner lenders' parameters, but data indicates some are having to "shotgun" credit applications in hopes of finding someone to accept a loan. Auto lenders should communicate their programs to dealerships so retailers know which deals are a good fit, Fontaine said.

Opdahl agreed, encouraging dealerships to develop close relationships with four or five key subprime lenders. The number of inquiries his company has received from dealerships nationwide represent a "red flag" indicating that multiple dealers might have lost a subprime lender and are hunting an alternative, he said.

By failing to recognize that "this might be the new reality," dealers are not really helping themselves, Opdahl said, as a $25,000 vehicle that any lender would likely have financed a year ago might find few takers today.

Panelists also touched on strategies that exist for dealerships seeking to assemble deals more favorable to subprime consumers and partner lenders willing to underwrite their debt.

Opdahl said his lender's dealership network faces the challenge of few quality customers and affordable vehicles. Competition from franchised dealers is unlikely to cease any time soon, he added.

The sales team at Automotive Credit encourages its dealerships to think in terms of vehicles their customers can afford, Opdahl said, as he sees affordability persisting as a subprime issue for the next 12 to 18 months. Even if used-vehicle values fall 10 percent, that's a "drop in the bucket" compared with their pricing growth over the past two-and-a-half years.

Dave Goodgame, COO for the independent dealership group Tricolor Auto, said down payments pose the largest affordability issue for the subprime sector. Goodgame, whose group provides buy-here-pay-here financing, said Tricolor's customers are "liquidity-constrained," and that inflation of household expenses, such as milk, cuts into the amount they have to spend.

"The big one is just going to be the down," he said.

Two challenges to improving affordability for subprime borrowers are higher interest rates and vehicle values, Fontaine said. Flagship is trying to determine who can afford vehicles and the models that can hold their value, he added.

Tricolor ran analytics on which models retain their value, Goodgame said. But the group thinks less in terms of book value and more in terms of Tricolor's consumer base and a vehicle's worth to an individual customer. For example, a customer who has a cleaning service or works construction might keep up with payments on a vehicle related to that job, he said.

Fontaine said that high residual values help cut the severity of a lender's loss when it must repossess a vehicle, but research shows vehicles that hold their value also cut down on the frequency of defaults. A consumer underwater on a loan has fewer options than one with positive equity, he said.

Tricolor wants customers to feel they have equity in their vehicles, Goodgame said. The group focuses on using front-end concessions, such as cutting its reconditioning margin, to keep payments comparable to pre-pandemic levels without reducing the vehicle's value to a consumer. Tricolor has experienced fewer issues than its peers because it considers customers' positions years into a loan, he explained.

Heading off repair bills also reduces a lender's risk with a subprime borrower. Opdahl said Automotive Credit considers the vehicle and its exposure to repair bills in evaluating a loan. The monthly payment is irrelevant if the vehicle's $2,500 transmission is compromised, he said.

The company also encourages vehicle service contracts. While finance-and-insurance coverage increases monthly payments, there's a risk in not having it, Opdahl said. Vehicle breakdowns are the No. 2 reason Automotive Credit finds customers failing to make their payments.

Goodgame said Tricolor gives consumers a free 12-month service contract and might throw in additional months of coverage. He described a scenario where Tricolor buys a 2017 model instead of a 2018 model to have a more affordable vehicle for sale — then extends the coverage another year. The company looks to buy the right vehicle and then apply the right protection, Goodgame said.