Having a car is a necessity for the millions of Americans who don’t have alternative transportation to get to work or school. When you have bad credit, that necessity can create a catch-22: you have to have a car to get to your job, but you need a job so you can qualify for a loan to get a car. With a low credit score, getting a loan with an affordable interest rate can be a monumental challenge. You need to dig yourself out of debt without risking making the hole even deeper.
For many car buyers, the solution is a subprime auto loan. Offered by a variety of lenders, a subprime auto loan is financing provided to consumers with very low credit scores. The lender offsets their risk by charging massive interest rates.
These loans of last resort can be a lifeline to a better financial future. Way too often, however, they’re a highway to financial disaster. In this guide, we’ll look at what subprime loans are, where to get them, and how to avoid needing one.
What Is a Subprime Auto Loan?
Subprime auto loans:
- Are made to borrowers with low credit scores.
- Come with very high interest rates.
- Are very expensive.
- Are available from a variety of lenders.
- Can attract very aggressive debt collection practices.
- Can come with vehicle tracking devices to make repossession easier.
They Are Made to Borrowers With Low Credit Scores
One of the most critical factors lenders look at when deciding whether or not to make a loan is the potential borrower’s credit score. A credit score is a number between 300 and 850 that represents the information in your credit report from the three leading credit reporting agencies – TransUnion, Experian, and Equifax. Your credit score is a predictor of your creditworthiness based on information about your debts, available credit limits, and history of making on-time payments. You actually have several credit scores, based on slightly different scoring models, but they're usually pretty close to one another. Credit scores are sometimes called FICO scores, but the Fair Isaac Company scoring model is just one of several that is used.
There’s no exact cutoff, but most lenders consider scores in the 550 to 650 range in the subprime category. Deep subprime borrowers typically have scores below 550, depending on the lender.
Subprime Loans Come With Very High Interest Rates
Lenders price their loans based on the creditworthiness of the borrower. That’s why subprime car loans have exceptionally high interest rates. They can be three times higher (and sometimes even higher still) than the rates extended to borrowers with excellent credit. Many subprime car loan borrowers can only afford used cars, which generally come with higher interest rates than new cars. The combination of having a bad credit score and buying a used car can launch the interest rate through the roof.
For the lender, it’s all about risk. Loaning money to a borrower that’s less likely to pay it back than other borrowers is risky to the lender. To offset the charge-offs they are likely to incur from borrowers who cannot pay back their loans, they simply raise the interest rates on those borrowers.
Our guide to average auto loan rates illustrates the range of interest rates in the market, based on credit scores.
Subprime Loans Get Very Expensive
Here’s an example to show just how much more expensive high interest rates can make a car purchase. We’ll say you’re buying a $10,000 used car and taking out a five-year auto loan for the purchase. A buyer with excellent credit could expect an interest rate of 3.31 percent. Using a car loan calculator to figure the compound interest, we can see that their monthly payments would be $181 and you would pay a total of $860 in interest over the 60-month term of the loan.
A borrower with a credit score of 600 could expect to pay 10.99 percent on their auto loan. Their monthly payment would jump to $217 per month. Over the term of the loan, they could expect to pay $3,020 in interest. That is $2,160 in additional interest to buy the same exact car.
For borrowers with deep subprime credit, the numbers get even worse. The average rate paid by a buyer with a credit score below 449 is currently averaging 15.67 percent. The monthly payment at that interest rate would be $241. A total of $4,460 in interest would have to be paid over the course of the loan.
If the numbers above give you the idea that the most expensive loans are given to the consumers least likely to be able to afford them, you’re right. That’s why taking a subprime auto loan is such a risky proposition for consumers with debt problems.
Who Makes Subprime Auto Loans?
Many lenders do subprime auto lending. They range from large national banks with hundreds of branches to online lenders, credit unions, finance companies, and specialized auto dealerships. Different lenders have vastly different reputations in how they work with subprime borrowers. Community banks and credit unions typically offer the best balance of customer service and low rates. Large banks often have inflexible lending policies and somewhat higher than average rates. Online lenders can have comparatively low rates, but sometimes lack the one-on-one customer service many borrowers with credit issues need.
Finance companies and dealerships that serve the subprime and deep subprime lending market should be approached with caution. While many of these companies treat customers with respect, there are some that prey on people with bad credit, putting them in debt traps that are difficult to escape.
Before you take a loan out with any lender, a Google search of the company name plus “complaints” can give you an idea of their reputation. Checking with the Better Business Bureau or another consumer advocacy group in the area where they do business can help you identify those lenders with complaints lodged against them.
Why Do Lenders Want to Make Subprime Loans?
Given the risks involved to lenders of making subprime and deep subprime loans, you might wonder why they bother. The simple answer is that there is tremendous profit potential for subprime auto lenders. By having a blend of loans with different credit risk profiles, they can manage their total risk, while maximizing their profit potential.
That’s why you’ll find some of the country’s most respected financial institutions involved in making loans to consumers with bad credit, even though subprime lending has a bad reputation among many consumer advocates.
What Is a Buy Here, Pay Here Lender?
Within the ecosystem of subprime auto lenders, there's a class of dealerships known as "buy here, pay here" lenders. You purchase a vehicle at these locations, often at a price that's higher than market value, then have to return to the dealership each payment period to make your car payment. The rates they charge tend to be higher than many lenders, and they are incredibly aggressive about collecting overdue loans, while tracking cars and repossessing them much more quickly and frequently than other lenders.
Unlike most dealerships who simply act as brokers to outside lenders and mark up their loans, buy here, pay here dealers are nonbank lenders, meaning the dealership makes the loans themselves.
Buy here, pay here lenders are often considered auto lenders of last resort, and consumer advocates recommend you try at all costs to avoid this type of dealership. The debt spiral you might find yourself in can be tough to escape.
How Do You Get a Subprime Auto Loan?
You can apply for subprime auto financing just like any other car loan. You fill out a comprehensive loan application, either on paper or online, with information about your income, assets, debts, employment, and other financial obligations. Auto lenders then look at the application and pull a credit report to build a picture of your creditworthiness.
At that point, they'll make a decision to approve or decline your loan. Sometimes a lender will come back with an approval that dictates different loan terms, such as a higher interest rate than you applied for, a larger down payment, a shorter loan term, or a smaller loan amount. Don’t get depressed if you are declined for a loan. It means that an auto lending professional doesn’t believe you have the ability to repay the amount you wanted to borrow. In the long run, the decision to decline the loan could save you from a default or bankruptcy.
Why You Don’t Want to First Apply at a Dealership
It is never a good idea to step foot in a car dealership without a preapproved financing offer in your pocket. That’s especially true if you have a subprime credit score. When you get a preapproved financing offer from a bank, credit union, or lender other than a dealer, it will help you set a car-buying budget based on what you can afford, rather than what car you're trying to buy.
Having a preapproved budget gives a car dealer a competitor they need to meet or beat if they want to get your business. Without one, the salesperson or finance manager will have no incentive to offer you a good deal on your financing. A substantial portion of auto dealer profit comes from marking up the interest rate or fees on financing offers that they arrange with outside lenders. In most states, they do not have to disclose the markup they are charging. Having a preapproved deal in hand limits their ability to add additional costs to their loan offer.
When you have a preapproved financing deal in place, you can focus on the price of the car without the complexity of negotiating both the loan terms and the car price bundled into the same transaction.
Our guide on preapproved auto loans explains the process and importance in more detail.
How Can You Avoid Getting a Subprime loan?
If you can avoid getting an auto loan while you have subprime credit, you should strive to do so. Financing a pre-owned or new car when you have a poor credit score is expensive and risky.
Improving Your Credit
By starting to look at your credit history many months before you get into the market for a new ride, you’ll have time to correct any errors on your credit reports and work to improve your credit score. While you can decimate your credit score with a single bad financial decision, raising it takes time and patience. Several months of on-time bill payments and reducing your credit card debt may help you move you out of the subprime auto lending market and into a much less expensive loan.
Even if it doesn’t raise your credit score enough to get into the next category of borrowers, being able to show an improving history of on-time payments may be enough to convince a loan officer at a smaller financial institution to give you an opportunity to prove yourself.
Finding a Second-Chance Lending Program
Some lenders, particularly credit unions and community banks, sometimes offer second-chance borrowing programs to customers with sketchy credit histories. The loan terms are often especially restrictive, but a second-chance loan can be a stepping-stone to a non-subprime auto loan.
Find a Co-Signer
Another way to avoid a subprime auto loan is the have a friend or family member co-sign the loan. It’s great for the person getting the car, but exceedingly dangerous to the credit score of the co-signer. Before you ask someone to co-sign a loan with you, both you and the potential co-signer should completely understand the risks and benefits.
Our article on co-signing loans describes in detail the pros and cons of co-signing an auto loan.
If you have no choice but to accept a subprime auto loan, it is critical you make all of your payments in full and on-time. After doing that for the first year or so of the loan, you put yourself in a great position to be able to refinance the loan with a better interest rate and loan terms.
Our guide to refinancing an auto loan shows you the steps to getting into a new loan with more favorable attributes.
What Happens When You Can’t Pay Back a Subprime Loan?
If you cannot repay your subprime loan, you’ll see your financial situation go from bad to worse. If you just have a late payment or two, there’s a good chance you can redeem yourself with a long series of on-time payments. Most responsible lenders don't want you to default on your loan and will work with you to make sure that doesn't happen. Unfortunately, some unscrupulous lenders have built a business model where quickly repossessing your car and then reselling it to another credit-challenged borrower is their goal.
By failing to make your payments, you not only risk a loan default that will destroy what's left of your credit rating and make it impossible to borrow again, but you also will likely have your vehicle repossessed and sold by the lender to satisfy the debt. In some states, you'll still be liable for the difference between the amount they get from selling the car and the balance of your loan.
It’s not uncommon for subprime auto lenders to have electronic auto trackers installed to make finding the car for repossession easier. Some go a step further, with systems that disable the vehicle until either a payment is made or they get the car back.
When you think you are in danger of missing a payment, your best course of action is not to hide from your lender. It’s a good idea to contact them, describe your circumstances, and work with them to find an equitable solution. If your issue is a one-time thing, they might allow you to skip a payment. If it’s a long term issue, they may work with you to sell the vehicle and get out from under the loan obligation.
More Shopping Tools From U.S. News & World Report
If your credit rating is subprime, you’re likely not in a position to handle both a car payment and an expensive auto repair. That’s why it is critical to use the loan to get a good car. Our used car rankings and reviews look at the cost of ownership, the consensus opinion of America’s top automotive journalists, and quantitative data on safety and predicted reliability.
Our guide to buying a used car shows a step-by-step process to get the right pre-owned vehicle at the right price. Reading our article on negotiating the price of your car describes tips and strategies you can use to get a good deal. Unfortunately, consumers with subprime credit scores will likely find new cars and leases out of reach.
A critical component of car ownership is having the right auto insurance. Our car insurance hub features information to find you the right insurance coverage, earn generous car insurance discounts, and work with top insurance companies.