It has been said that the first step in getting yourself out of a hole is to stop digging it deeper. But there’s a segment of the auto lending industry that is more than happy to give you a shovel, enabling you to get in so deep that there’s no way out.
For many, having a car is essential. You have to get to work to make a living, and not everyone lives where there’s effective public transportation. However, not everyone has great credit, and some have no credit rating at all. For them, the only solution appears to be subprime lenders who advertise that they can make loans to anyone, regardless of their credit history (or lack thereof).
As documented in a recent piece on HBO’s Last Week Tonight with John Oliver, the subprime auto lending landscape is a treacherous route to tread, and one with the potential to cripple you financially for years. The riskiest territory is the “Buy Now, Pay Here” type of used car dealership. Because no traditional financial institution is used to back the transaction at these dealers, there is less regulatory oversight of the loans that they make. Buyers are often required to return to the dealership twice a month to make cash payments, hence the name Buy Here, Pay Here.
There’s a catch, however. Borrowers will be forced to pay extremely high interest rates to counter their credit risk, and they’re often forced to pay much higher prices than the Blue Book value of the car.
“Subprime lending is inherently more expensive; it is not uncommon to see auto loan interest rates of between 25 to just shy of 30 percent,” says Chris Kukla, EVP of the Center for Responsible Lending. Unfortunately, that’s only part of the problem, as many extras are often packed on top of an inflated vehicle price. “Lenders are layering on top of that, with additional practices that significantly increase the risk that the person won’t be able to handle paying the loan,” Kukla says.
Packages such as extended warranties, vehicle service contracts, and gap insurance can add thousands to the amount being financed, which has the potential of making the loan amount significantly greater than the car is worth. Lenders count on the theory that borrowers will forgo other debts before they risk losing the car that gets them to work and back.
If you’re thinking that some players in the subprime lending market are preying on people who are barely scraping by as it is, you’re right. Some lenders bet on the idea that the borrower won’t be able to pay the loan back. More than 1 in 4 borrowers default on the loans, and their vehicles are aggressively repossessed so that they can be resold to another desperate borrower, starting the cycle all over again. Some lenders employ technology that warns the driver that payments are overdue, and then shuts the vehicle down if payments are not made. Systems can transmit GPS data so that the car can be easily recovered.
A story on the industry by the Los Angeles Times tracked a vehicle that had changed hands eight times in three years, with multiple repossessions along the way.
Some in the industry contend that they are providing a service to people who would not otherwise be able to buy a car, but Kukla sees it differently. “That’s the go-to argument for lending we otherwise ought not to do,” he says. “To make a loan, not taking into account whether the person can sustain the loan, that’s the question: Are you doing them a service, or are you causing them to struggle?”
So how can someone with bad credit avoid the pitfalls of subprime lending? First of all, not all subprime lenders are created equal, and some are more consumer-friendly than others. Before you approach them, you need to give your local bank or credit union a chance to finance a loan.
“Don’t assume that your bank or your credit union is going to say no. You should at least ask the questions,” Kukla says. “Often times they may have a program that may be available to you.”
“You can save yourself thousands of dollars or even tens of thousands by continuing to ask the question, and fighting through the ‘No,’” he says.
As auto manufacturer’s captive finance companies continue to take a large share of top-tier borrowers, banks and credit unions are becoming more willing to make loans to borrowers with less-than-stellar credit. While you will still pay higher rates than borrowers with excellent credit, the rates are often lower than dedicated subprime lenders offer.
If you are able to get financing approved outside of a dealership, you have a lot more power in the final transaction. The financing offer you take into the deal becomes the baseline that dealers will try to beat. As much of their profit comes from financing, it’s something that they are liable to fight to keep.
Finally, time is your friend. Whether that means you have to endure public transportation for a time, or choose a cheaper car – the longer you have to rebuild your credit, the better. Defaulting on a high-interest subprime car loan that you couldn’t afford in the first place will have the opposite effect on your long-term credit picture.
You need a ladder to get yourself out of the hole of bad credit, not a shovel to make it deeper.
Before you head out to buy a used car, be sure to take advantage of the resources of U.S. News & World Report’s used car buying research. There you’ll find information on the best used car deals in the marketplace, and see the rankings of best used cars by category. Stay up to date with the latest buying tips and advice by following us on Twitter and Facebook.