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The ‘new affordability’ of extended-term auto loans is making it more difficult for lenders to assess the risk of these loans — particularly in the near prime and subprime consumer segments, where there are opportunities for growth but higher-than-average default rates. Having a risk score that uses a longer performance window can assist lenders in identifying viable acquisitions they may otherwise have declined, and providing consumers with access to the credit they need. Alex Semenov, Analytics and Consulting Advisor at TransUnion Canada, suggests a new approach.
According to a report issued by the Financial Consumer Agency of Canada, Canada’s auto finance market grew by almost 100% in eight years, from roughly $60 billion in 2007 to $120 billion in 2015. In addition, the growth of consumer debt in auto loans was greater than all other types of household credit1. To make auto ownership more affordable, many are opting to pay lower instalments over a longer period. Extended-term loans (60, 72 and 84 months) are becoming more common: according to the same report, in 2015, these types of loans made up approximately 60% of the auto loan portfolios among Canada’s largest lenders.
This ‘new affordability’ has its benefits for consumers who simply can’t commit to higher payments over a short term. But on the flip side are those who may be tempted to financially commit more than they should to procure a more expensive vehicle — and will quickly find themselves facing difficulties if their financial circumstances change. The FCAC Auto Finance: Market Trends report notes that approximately 25% of Canada’s auto finance market is below-prime.
The auto finance market may be expanding, but competition is high in the Canadian market. Those that focus only on consumers in the prime-and-above segments may find their opportunities limited. When looking for ways to grow revenue and market share, lenders can look to offer credit to non-prime consumers.
A TransUnion Canada analysis of credit and auto loan trends between Q3 2017 and Q3 2018 found that the distribution of new-account risk skewed toward expansion in below-prime segments (see chart below).
In our analysis, larger auto balances also skewed toward higher risk.
Owning a vehicle is a significant investment for many — generally second only to buying a home. Yet we see a higher degree of defaults on auto loans than on mortgages. In the hierarchy of household payments, auto loans appear to feature fairly low on the priority list. When times are tough, it appears that they take a back seat to paying the rent or mortgage.
The trend toward extended-term loans can be a concern for lenders, as it may be more difficult for them to determine a consumer’s affordability. Using a traditional credit score helps to assess creditworthiness, but these scores generally give a six-to-twelve-month view.
This potentially limited insight into long-term payments and the likelihood of a consumer going past due can create additional risk exposure. However, this view could also limit viable acquisitions: near prime or subprime consumers, who may be good prospects, could be declined based on their traditional credit score. According to TransUnion’s study, despite an increase in consumer debt overall, delinquency rates on auto loans have remained stable.
TransUnion recently assessed a risk score for the subprime population that leverages a longer duration of consumer payment data on auto loans and other retail credit products, and is tailored to the unique needs of auto loan providers. We found that a longer performance window allowed for a better risk assessment of long-term auto loans and leases — which in turn would result in more informed decisions.
Lenders that can better predict behaviour and the likelihood of repaying an auto loan will be in a stronger position to consider consumers who had previously been declined based on their traditional credit score — and grow their portfolio while managing risk exposure. TransUnion’s CreditVision Subprime Auto Score uses auto, payments and collections data to help lenders improve their assessment of risk for this consumer segment to help increase revenue and give consumers better access to credit.
1Financial Consumer Agency of Canada (“FCAC”), March 2016. Auto Finance: Market Trends.