TOM: Good morning!
MELLODY: Good morning, Tom.
Tom: We have a serious topic this morning – subprime lending is making a comeback.
Mellody: That’s right, Tom. In recent months we have seen subprime lending surge, and there have been some worrying signs that the practice that was responsible for the housing crisis is bleeding into other industries. We have talked about the practice on Money Monday in the past in reference to auto loans, but now we are seeing it emerge in personal loans and credit cards.
Tom: That’s not good news. First thing out of the gate – what comprises subprime and what does it usually mean for the borrower?
Mellody: Generally, subprime borrowers are those with a credit score below 650 on the scale that goes from 300 to 850. If you fall in this category because you have fair, poor or little credit history, you will have a much more challenging time getting approved for loans, and when you do, you will pay a much higher interest rate.
Tom: OK. So what is the scale of this new trend?
Mellody: It’s big, Tom. A data from credit firm Equifax shows that almost four of every 10 loans for autos, credit cards and personal borrowing in the U.S. went to subprime customers during 2014. That amounts to more than 50 million consumer loans and cards totaling more than $189 billion! This is by far the highest level of subprime lending we have seen since 2007, when subprime loans represented 41% of consumer lending outside of home mortgages.
And that is not just among traditional lenders. There are new alternative lending channels out there that are extending loans to individuals who fall into the subprime category. Many of these non-bank lenders catering to subprime borrowers argue they are simply occupying a niche left open as larger banks and traditional lenders have limited lending to higher risk individuals, decisions that have to some degree been driven by regulation.
But these companies can be very dangerous for borrowers. One company that offers unsecured personal loans in the U.S. to borrowers with average credit scores between 580 and 625, and charges fixed interest rates of 36% to 365%! Subprime auto loans also continue to boom, and car loans account for most of the increase in overall subprime lending in the last few years. Subprime car-loan originations totaled $129.5 billion during the first 11 months of 2014, or 68% of consumer subprime-loan volume, according to Equifax.
Tom: What is driving this trend?
Mellody: From the lenders’ side, the motivation is profits. Just like the surge in mortgage lending to individuals with fair or poor credit ahead of the housing crisis, this has been driven by banks and other firms seeking to turn a profit off of high interest rates that people are paying on these loans. And like the mortgage bubble, many of these loans are being bundled into bonds and then sold as securities. From the borrowers’ side, it is really being brought to the fore after years of improving financial health.
After the mortgage crisis, Americans really tightened their belt and have been paying down their debt. Borrowers with a FICO credit score of less than 650 owed roughly $48,000 on average across all debt obligations. That figure was roughly $55,000 in October 2012 and about $61,000 in October 2008. Now however, with the economy improving and consumer confidence returning, people are moving beyond their self-imposed austerity, and they are buying cards and running up credit debt again.
Tom: Are we seeing subprime loans in housing again?
Mellody: Thankfully, no. The one big exception to the rise in new subprime loans has been mortgages, which were the epicenter of the financial crisis of 2008. Mortgage lenders remain focused on borrowers with solid credit, according to industry data. Some $4 billion of subprime mortgages have been given out annually since 2009, down from a peak of $625 billion in 2005, according to trade publication inside mortgage finance. To put that in perspective, as late as 2007, nearly 20% of home loans were made to subprime lenders. Last year, that number was around .3% of home loans. So on the housing front, regulators and lenders seem to have managed to keep the practice in check.
Tom: Speaking of regulators, have there been any efforts to protect borrowers from crushing interest rates?
Mellody: There are some initial efforts out there. The consumer financial protection bureau is investigating ways to mandate that short-term lenders cross-check loan amounts and rates against the applicant’s ability to repay the loan. This requirements already exist for credit cards and home loans, but extending it to short-term loans would provide a greater deal of protection.
Additionally, some states already place caps on the interest rate that can be charged on loans, which prevents some of the less savory lenders from operating within their borders. However, this does not mean you are protected! The best bet here is to be honest with yourself about your finances, and stay far away from loans with high interest rates. Even with the economy improving, the best bet is to save your money for a rainy day, and a sunny retirement!
Tom: Thanks again for always looking out for us, Mellody!
Mellody is president of Ariel Investments, a Chicago-based money management firm that serves individual investors and retirement plans through its no-load mutual funds and separate accounts. Additionally, she is a regular financial contributor and analyst for CBS News.