Drivers who took on auto loans at high interest rates and paid sky-high prices for cars could face some headaches down the road as car values pull back in an economic slowdown.
The car you're looking to trade in — particularly if you bought a used car — could be worth far less than you'd imagine. And lenders are growing more concerned about people falling behind in their car payments, especially if that car drops significantly in value.
The outlook is most worrisome for borrowers with subprime credit scores who bought used cars as prices and interest rates hit a peak.
"They often go and purchase a vehicle because they really need it," Satyan Merchant, senior vice president of the auto business at TransUnion, told the Free Press.
How negative equity is a growing worry
The new and used auto market is moving farther away from the days of shockingly low supplies on car lots that contributed to skyrocketing prices. In some cases, used car prices are going down more than they have in the recent past.
Negative equity — or owing more on your car than it's worth — is building, particularly in used cars bought by subprime borrowers, according to a new study called "Finding Opportunity in Uncertain Times" by TransUnion and J.D. Power.
Not surprisingly, the researchers noted, consumers with more equity in their car or truck appear more likely to protect that equity by making payments.
The real problems pop up when someone needs to buy a new car — and doesn't have $3,000 or $5,000 sitting on the sidelines to cover what they still owe on the old car that they'd like to trade in. You might have to take on an even bigger car loan and an even bigger monthly payment to get another set of wheels.
Or try to sell that car on your own to get a better price. Or delay buying, if you can.
What is a loan to value ratio?
The auto industry pays close attention to loan to values ratios — the difference between the loan amount and the market value of the car. The higher the number, the more vulnerable the consumer.
In the first quarter of 2023, the average loan to value ratio on a used car bought then was 125% — up from 112% three years earlier. In this case, you'd owe 25% more than the used car is worth.
Rising loan to values are important to consider, according to Merchant, because they can be used to predict higher delinquencies among used auto finance customers, particularly with subprime customers.
As vehicle values have declined in recent quarters, TransUnion noted, used car loan-to-value ratios at origination have trended upward.
Used cars and trucks prices were down 4.2% year-over-year through May; new vehicle prices were up 4.7%, according to the Bureau of Labor Statistics. New vehicle prices did edge down a slight 0.1% in May in month-over-month data but used car prices in the monthly data were up 4.4%.
More: Fed leaves interest rates alone for now, as inflation cools
Merchant has been encouraging lenders to use additional tools offered by TransUnion to spot vulnerable consumers, such as ways to gauge the consumer's ability and willingness to pay more than the minimum monthly payment on their credit cards and other revolving accounts. Paying more than the minimum can be a positive sign for a consumer. But if consumers start paying less than they usually paid, say $50 extra per month on credit card debt instead of $200 extra, it can be a red flag to trouble ahead.
It's important to know how consumers are handling all of their bills.
According to the Fed's Quarterly Report on Household Debt and Credit, total household debt reached $17.05 trillion in the first quarter of 2023, increasing by $148 billion or 0.9%. Balances are $2.9 trillion more than at the end of 2019, before the COVID-19 pandemic and before the devastating but short-lived recession hit in 2020.
Auto loan balances increased by $10 billion in the first quarter to hit $1.56 trillion, a time when typically auto balances tend to decline, according to data released in May by the Federal Reserve Bank of New York's Center for Microeconomic Data.
The last three years have been a roller coaster for the auto industry, according to the TransUnion-J.D. Power report, as supply chain disruptions hit during the pandemic. Consumer demand remained high, thanks to extremely generous government stimulus payments, just as supply tightened.
A shortage of new cars — following cuts in production in the early days of the COVID-19 pandemic — quickly drove up the values of used cars.
Used car payments are already higher
The average payment on a used car bought in the first quarter of 2023 hit $523 a month. That's up nearly one-third from payments of around $395 a month for used cars bought in the first quarter of 2020, according to the new TransUnion-J.D. Power report.
Some 10% of used car loans taken out in the first quarter of 2023 were for seven years or longer, according to TransUnion. That's up from 5% in the fourth quarters of 2019 and 2020. Borrowers need to extend those loans to create a more manageable monthly payment.
We're already seeing some evidence that younger borrowers are struggling making their auto loan payments and credit card payments, according to a blog by the New York Federal Reserve Bank called "Liberty Street Economics."
New car and used car prices skyrocketed to ridiculous levels in many cases, leading consumers to borrow more to pay for the vehicle. The average amount financed for a new car in January 2019, according to data from Edmunds, was $31,707.
By contrast, the average amount financed for new cars was $40,381 in May — up about 27% in just four years. The average car loan rate was 7.1% on vehicles bought in May — up from 6.2% in January 2019.
For used cars, the average amount financed was $29,736 in May, according to Edmunds data. That's up more than 36% from an average of $21,763 in January 2019. The average auto loan rate for used cars was 11% in May, up from 8.9% in January 2019.
More: Record number of buyers opt for $1,000+ car payment
More: US credit card debt soars: What to know about rising rates, balance transfers
It's possible — though there is some speculation to this — that the creditworthiness of younger borrowers might have been inflated to some degree during the pandemic. Theoretically, some could have looked more qualified to take on an auto loan than they might have been. We will see in the months ahead how this turns out.
The blog by the New York Federal Reserve Bank noted that auto loan underwriting standards appear to have been relatively steady during the pandemic. Among some consumers, there was a "decreased accuracy of credit scores as a measure of a consumer’s true credit worthiness," the blog stated. Temporary financial relief during the pandemic ended up boosting some credit scores, the blog noted, by making most delinquent federal student loan borrowers current on their loans.
Student loan payments — which often can be about $400 a month — are expected to resume in October, according to the U.S. Department of Education. Borrowers will be notified well before payments restart.
Will some consumers who haven't had to make student loan payments since March 2020 feel even more pressure as they resume making payments? Does it put a squeeze on budgets in 2024?
Some delinquency data appears to be forecasting more potholes and speed bumps. Historically, many consumers pulled out all the stops to make car payments when they faced financial challenges because they need the car to get to work. Will that be true in if the remote work trend continues? Or if the jobless rate goes up?
Many consumers have been able to pull out their credit cards — or dig into savings — to cover their higher expenses as inflation has soared. But what happens as high prices linger? What bills might get paid late or not at all?
Contact personal finance columnist Susan Tompor: stompor@freepress.com. Follow her on Twitter @tompor.
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