How to Protect Yourself From the Auto Loan Bubble

During the Great Recession, one of the biggest triggers was the collapse of the housing loan bubble. Too many lenders were giving loans to those who had poor credit (called subprime loans). These borrowers would then be stretched too thin, and many stopped paying on their mortgage. Mass defaults caused a major economic collapse.

Some economists are now predicting the same thing could happen in the auto loan market. As of December 2016, as many as 6 million subprime borrowers were at least 90 days behind on loan payments. In addition to that, loan terms are extending and prices for new vehicles are going up.

If the auto loan bubble were to burst, it wouldn’t have the catastrophic effects that the housing bubble did. But it’s something that would still be felt by the average consumer. Lenders would be forced to tighten their lending policies, which would make it harder to get an auto loan. Plus, if you were to receive a loan, it would likely be at a higher interest rate.

However, not everyone sees the current conditions as a troubling sign.

“Although delinquencies for the overall industry are rising slightly, we see that many auto lenders are taking prudent steps to manage their risk exposure,” says Brian Landau, senior vice president and automotive business leader at TransUnion. “Some of these actions include tightening underwriting standards, particularly in the subprime and near-prime segments, and doubling efforts in other segments of the credit spectrum. Lenders also are leveraging alternative data to better evaluate the risk of non-prime borrowers.”

One of the biggest risks of a bubble collapse is when there is more money tied up in loans. This money creates the bubble that, given mass defaults, could collapse. The auto loan bubble has grown immensely in the last six years.

According to Bloomberg, outstanding auto loans totaled a little less than $700 billion at the end of 2010. By the end of 2016, that number had climbed to $1.1 trillion. But a bigger bubble alone isn’t a danger. The trouble lies in who those loans are going to: more subprime borrowers means the bubble is more likely to pop.

Why is the amount of outstanding loans climbing so rapidly? It’s a variety of factors, really. On the one hand, the recession officially ended in 2009. That means for the last eight years, we have seen economic growth (historically we enter a recession about every six years from the ending of the previous one), and that growth has given people confidence. Despite the fact that the average household income is roughly $57,000, people are taking out auto loans for an average of $30,000, or more than half their annual incomes.

More people buying vehicles (thus more loans on the books), bigger loans and longer terms mean one thing: more money in outstanding loans. This can create a problem when you’re underwater, meaning you owe more than the free-market value of your car, just as was seen in the housing market a decade ago.

In 2009, the most popular loan was a five-year term. By 2016, those had dropped in popularity, and the six-year loan has taken over. But the seven-year loan is also gaining popularity. The reason: loans for more expensive vehicles need longer terms to pay off to keep monthly payments at a manageable level. But vehicles depreciate quickly, so for a person who has a seven-year loan, after two years they often owe more on the vehicle than the vehicle is actually worth.

But keeping monthly payments low isn’t a bad thing, right? The longer terms make the monthly payments lower, and that should mean more people are able to purchase vehicles that they otherwise wouldn’t be able to afford.

In theory that’s how it would work. In reality, however, it doesn’t work out that way.

It is known that lower credit means you are more likely to default on your loan. According to FICO, 16.78% of those with poor credit will default on their five-year auto loan about the three-year mark; only 0.38% of those with good credit will default on the same loan.

What is surprising, however, is that when you make the term longer, more people default. Even more surprising is that the increase is greater with a higher credit score. With a six-year term, the percentage of defaults among poor credit borrowers grows to 19.24% (a 15% total increase in comparison to a five-year term), and among good credit borrowers to 0.7% (an 86% total increase).

For quite a few years now, automakers have been offering generous incentives to help move inventory. It’s caused consumers to upgrade their cars like they would their wardrobe. But it’s time to take a step back and consider the big picture. The Federal Reserve has promised several rate hikes in the near term. If that happens, there could be trickle-down effects for you.

This means that items such as your car could become less affordable. If you are already paying more than you should, then it could become a serious issue.

So what should you be doing to protect yourself? It starts with responsible borrowing. Don’t look at how much the bank is willing to lend, look at how much you can actually afford. The average financing on a new car loan is $29,469. However, the median household income is only $57,616. So while some might say this is an auto loan bubble, it might be better to call it an affordability issue.

When purchasing your next car, consider the 20/4/10 rule of car buying. You should be able to make a 20% down payment, while keeping the term of the loan at four years. Plus, your monthly payment shouldn’t exceed 10% of your gross monthly income. Just because a lender will approve a larger loan or allow you to extend the terms, it doesn’t mean you should. Keep in mind that a longer term loan usually means a higher interest rate, increasing the overall cost.

Higher-priced vehicles and longer loan terms create more outstanding debt. Longer loan terms lead to an increased rate of default among all credit scores. This results in a bigger bubble more likely to burst, and it will cause more damage if it does.

Here’s the good news: The default rates among those with good credit are below 1%, even for the longer term loans. those with good credit are 27 times less likely to default. Also, Forbes reports the number of subprime loans is decreasing. And while $1.1 trillion in outstanding auto loans is a big number, it’s still a lot less than the $8.9 trillion in the housing market.

Is the auto loan bubble going to burst? The amount of outstanding auto loan debt in the U.S. is entering unprecedented territory, leading some economists to sound the alarm. But given what we know, even if it does burst, it won’t have nearly the widespread negative effects that a housing bubble burst would have.