It really is a mixed up, muddled up, shook up world. It seems like everyone in 2021 took out a loan on a new car, even though we all knew supplies were low and demand was high. As the Financial Times pointed out:
“Americans went shopping for cars in a big way during the pandemic. Auto-loan originations in the U.S. hit a record $734bn in 2021, according to data from the Federal Reserve Bank of New York. Total outstanding debt in the sector grew by $84bn to $1.46tn, outpacing the increase seen in student and credit card debts combined.”
In March 2020, due to COVID lockdowns, the Seasonally Adjusted Annual Rate (SAAR) of auto sales collapsed to 11.4 million vehicles from the average of 17 million vehicles each year since 2014. By September, SAAR had returned above 16 million.
2021 was a mix of constrained inventory and pent-up demand. Sales increased 3.1% over dealers sold out inventories, transaction prices climbed to record highs, and incentives remained low. The average transaction price for a new vehicle reached $45,743 in December 2021, while used vehicles rose to $25,904, up 19.1% year-over-year. Skyrocketing transaction prices were buffered somewhat by high trade-in values, longer loan terms, and low interest rates. The average new vehicle monthly payment was around $622, up only 6.4% compared to an average 17% increase in transaction prices. More loan terms are now in the 72-84-month range in an attempt to lower monthly payments.
This year, Ford announced 84-month financing on used cars. And even Honda, whose U.S. sales chief said in 2015 that 84-month loan terms were “stupid,” is jumping on the 84-month loan bandwagon.
People are still buying cars. Carmakers are still struggling to get vehicles out the door. Fewer cars are being sold, perhaps, but profits are reaching record highs. Up until now, it’s all good. Until it isn’t.
The inevitable end of the chip shortage will expand the pool of vehicles to choose from and lower transaction prices as the market moves toward some semblance of normal. According to Automotive News, used car prices might plunge by 20% to 30%. The historic lows for auto loan defaults and repossessions, fueled by the combination of federal assistance and loan accommodations developed by auto lenders, will come to an end. Millions of consumers who took advantage of these assistance programs will be at higher risk for default, just as car prices plunge.
This plunge will be a relief for consumers, but it spells trouble for lenders who financed used vehicles at elevated prices and find themselves underwater if they need to repossess those vehicles. When used car prices weaken, lenders who have extended large loans may take a different view of the risks associated with repossession, storage, sale preparation, and attorney fees.
In today’s mixed up, muddled up, shook up world, a business model that encourages — and even desires — some level of repossession can provide substantial profits to the lender (depending on state regulations). Currently, lenders can typically get more money from the sale of a repossessed vehicle at auction than is owed by the borrower. This motivates many lenders to favor repossession over resolving delinquencies. Lower used car prices will revert the industry back to more normal “deficiency” conditions where lenders will still need to collect the amount owed from the consumer after the sale of the car, plus any other fees they owe under the contract — fees related to the repossession, lease early termination, finance contract early payoff, and attorney fees for deficiency judgments. Collecting on borrowers who have already lost their vehicles is hard and expensive work. Clearly, motivations will shift to resolving delinquencies, working with borrowers, and keeping consumers in their cars.
If the easing of the chip shortage isn’t enough to worry lenders with large auto portfolios, then record-high inflation, rising interest rates, and higher gas prices may be the issues they can’t maneuver around. Consumers are feeling the effects of rising prices. Financial well-being in the U.S. is shifting. Consumers ended 2021 with record levels of debt, leading into a year in which interest rates are rising substantially, and the significant levels of debt are starting to reflect in delinquencies.
Since July, auto defaults have been creeping up again, according to the S&P/Experian Auto Default Index. Some disturbing statistics:
- The likelihood of auto loan default increases with the size of the car loan – the average loan amount is $34,635 for a new vehicle and $21,438 for a used vehicle
- Gen X has the highest average auto loan balance ($19,223), and Gen Z is the single demographic most affected by auto loan delinquency rates
- The average car loan length for a new car reached a record high of 70.6 months in 2021 – and in 2020, the car loan length for used cars was longer than for a new car
- The proportion of auto to consumer debt has hit a 10-year high, rising to 9.5%, up from 5.8% in 2010
- 5.1% of auto loans in the U.S. are behind on payments (vs. the long-term average of 3.44%), and nearly half are underwater – this marks the second-highest percentage since 2010 when delinquency rates reached 5.27% during the Great Recession
- About 2.2 million vehicles per year are repossessed – that translates to 226 car repossessions per hour and 5,418 repossessions per day; for every 2.4 new vehicle purchases, there is one car repossession
- Subprime 90-days-overdue-or-greater defaults have risen to a decade-long high
- In 2021, subprime delinquency rates hit the highest mark since 2009
And if all this wasn’t enough to keep a credit risk manager from sleeping well at night, consider this: A recent Consumer Reports study found that auto loan portfolios may be riskier than previously thought. Specifically, the study of over 850,000 loans found:
- Loan terms were not necessarily correlated with credit scores – Borrowers in every credit score category were given loans with APRs ranging from 0% to more than 25%.
- Many borrowers were put into loans they can’t afford – Experts say that consumers should spend no more than 10% of their income on an auto loan, but almost 25% of the loans reviewed exceeded that threshold. Among subprime borrowers, that number is almost 50%, about 2.5 times more than prime and super-prime borrowers.
- Underwriting standards are often lax, with lenders rarely verifying the income and employment of borrowers to confirm they had sufficient income to repay their loan. Of the loans reviewed, verifications happened only 4% to 64% of the time.
- Delinquencies are common. More than 5% of the loans in the data — 1 in 20, or about 43,000 overall — were reported to be in arrears.
So, let’s recap where we are:
- Consumers are taking on ever-increasing auto loan debt for terms of almost a decade.
- Many consumers cannot afford these loans.
- Delinquency rates are rising to levels not seen since the Great Recession, especially among Millennials and Gen Z.
- Rising inflation, interest rates, and gas prices, along with the ending of pandemic-related relief programs, expose millions of consumers to the risk of default.
- Many auto loan portfolios have unknown risks embedded in them.
- The end of the chip shortage may lower transaction prices by as much as 20% to 30%, causing millions of people (and their lenders) to be severely upside down on a vehicle with years left in their loan terms.
It’s not pretty. In 2008, when the housing bubble burst, homeowners lost the houses they could no longer afford. There are warning signs that we are in an Auto Loan Bubble, and while this might not present the same systemic risk to the financial system as the implosion of the Mortgage-Backed Securities bubble, millions of consumers, investors, and lenders could be in for a world of hurt.
What can a Lender do?
Perficient’s collection and recovery experts believe that auto lenders who modernize their debt collection practices will be better positioned to successfully weather the coming storm. We believe now is the perfect time for auto lenders to address their debt collection operations. Consumer contact preferences have shifted, there are new rules regarding debt collection communications, and rising delinquency rates are causing increases in work and contact volumes. Forward-thinking lenders want to provide “empathy at scale” to get paid first, maximize customer lifetime value, and create more loyal customers.
Lenders doing more of the same old thing won’t succeed. Squeezing as much money out of delinquent borrowers as possible, aggressively collecting debts through repossession and wage garnishment, hounding borrowers with relentless calls to collect, and forcing borrowers into bankruptcy to avoid having their vehicles repossessed is not good business. When defaults happen, the impact on consumers’ lives and lender reputations can be catastrophic.
Our debt collection offerings meet a growing, immediate need to assist lenders and finance companies in improving their debt collection function, paving the way for the focus to shift back to the customers’ financial well-being and loyalty, resulting in lower delinquencies and charge-off rates. Our goal is to help lenders humanize debt collection through empathy and personalization strategies. We know it works.
Infusing empathy in a debt collection customer interaction is the key success factor resulting in a mutual win for the borrower and lender. It makes borrowers feel their lenders understand how their situation and gives them confidence that their lender sees the problem as being just as important as they do. Empathy helps lenders provide an experience where borrowers feel respected, understood, and supported. Borrowers will always choose to pay lenders that create a culture where collectors are hyper-customer experience focused over lenders that don’t. It always results in a mutual win, and lenders who use this strategy experience significant improvements in delinquencies, loan loss rates, and customer loyalty.
Empathy at scale and humanizing the collections experience requires an approach that balances business strategy, business processes, organization structure, systems/tools, and performance measures. It requires:
- Expanding digital capabilities to not only engage borrowers in their “channel of choice” but to keep them in that channel to promote call deflection
- Sophisticated segmentation to address different borrower behaviors and risk levels – the days of only sequencing activity based on days past due must change
- A sequencing approach for automated touchpoints (technology) and contact strategy that can adapt through artificial intelligence to hyper-segment borrower populations
- Personalized messaging to humanize the interaction based on risk factors, credit score, days past due, customer value or loyalty, and other factors
- Process optimization that operates efficiently, audit-free, and maximizes the potential of the collection function before adding and layering in technology
- Reporting and analytics to set and measure goals and forecasts for every process and function related to those goals
- A solid data management and orchestration capability along with real-time or near real-time decision making
