What's Worse Than a Subprime Auto Loan?

From Megan McArdle.

"Subprime auto loans lend themselves to heartrending stories: Single mothers who take on loans with double-digit interest rates just to get themselves to a job that pays an extra $4 an hour. Gimcrack cars sold at nosebleed prices to desperate people. The repossession that strands you at work or in the house just as your ailing mother needs to go to the emergency room.

The New York Times has been running a series of these, with all the usual sad tales. The latest installment covers the high-tech devices that lenders now use to make sure that they get paid (or get the car back), from GPS systems that check to see whether you’re still going to work every day to ignition kill switches that can be triggered remotely to prevent people who have missed payments from starting the car. All these stories are troubling, but there’s something missing here: an analysis of whether the borrowers would be better off without these devices. I suspect that for many of the people in question, the alternative to no remote monitoring is no car at all.

We’ve talked before about what the credit-scoring revolution did to the market for auto loans: better rates for the best credit risks, high down payments and interest rates for people with spotty payment histories. The people being targeted for remote monitoring and deactivation are the most marginal of the marginal credit risks, as indeed the latest story makes clear; many of the subjects seem to be chronically behind on their payments.

Lending to people who pay late multiple times a year is an expensive business, especially when you’re lending on an asset that can fairly easily be hidden from you. If a borrower doesn’t make their monthly nut, the lender has to go to the expense of sending a tow truck to find the car and bring it back to the lot. Borrowers know this, so they quite sensibly tend to put the car payment later on their list of priorities, behind more urgent items such as food, utilities and rent.

Don’t get me wrong: I'm not saying that the people who lend money to bad credit risks are splendid, public-minded fellows. It’s a tawdry business that most decent people prefer not to be involved with, because we’d find it difficult to take a car away from a sobbing single mother with three small children clinging to her legs -- and then we’d lose money on all our nonperforming car loans and have to get into some other line of business. Lending to financially unstable people who are unlikely to repay you without the application of serious leverage is usually a job for the hard-hearted. The subtext of many of the articles on subprime auto loans seems to imply that the dealers ought to let these poor people off the hook because they’re having a really difficult time. But that’s a hard precept to follow when your whole customer base consists of hard-luck cases.

And if those people don’t lend, are their would-be borrowers better off?

As a financial columnist, I always advise people to avoid subprime loans at all costs. Give up alcohol, cigarettes, meat and fun, and save up as fast as you can for something in decently good shape but ugly as sin. I offer that advice for housing, cars and anything else you might want to borrow money to buy.

But what if someone hasn’t followed that sterling advice and their car just broke down or their conveniently located employer just laid them off? Would I make them better off by making it easier for them to default -- and therefore harder for them to get a loan in the first place? I’m not so sure. It’s all very well to say that it would be better to have higher wages or better public-transit networks so that single moms don’t need a pricey car to get to work, but you can’t really let the kids go hungry while you wait for the urban-planning renaissance to arrive.

You see this with payday loans as well. Payday loans are really, really expensive, and you should never take one out if you can possibly avoid it. But when you talk to people who have done so, you often find that the loans were used to avoid some even more expensive disaster such as having your paycheck garnished, missing a registration deadline for classes, or getting your utilities shut off and having to pay $150 to get them reconnected.

Of course, you also see people who use payday loans to pay for a kid’s graduation party, then get trapped in a borrowing cycle where that $200 graduation party ends up costing $1,000 in interest. And there’s the rub: As experiments have shown, these markets are characterized by very binary outcomes. The majority of people are better off with the loans, but a substantial minority end up worse off. I suspect that if you did a study of subprime auto borrowers -- one that compared their experience to the strong possibility of no car at all, rather than a utopian universe where people with spotty payment histories somehow qualified for prime loan rates -- you’d see very similar results.
It’s good that these stories are highlighting how hard it is to be poor and in debt. But what’s missing is what we can’t see: how much harder it might be if they couldn’t get those loans."