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What is new in the auto loan industry that we need to know about?

Mellody: You may have already heard that the auto industry is booming. Last year, auto sales broke records. And in november, U.S. auto sales rose 3.7% compared with a year ago. Wage growth, consumer confidence, and cheap gas have all contributed to the continued strength in auto sales. But one of the key contributing factors continues to be easy credit. Auto lending is on pace this year to hit the highest levels in 17 years, and with it we have seen more and more Americans taking on loans that are putting them in financial distress.

What is behind this boom in lending?

There were a few factors. First, the average age of the American car fleet is at a record 11.6 years old, even as auto sales continue to be strong. There is a lot of pent-up demand for newer cars. There is also demand among lenders to provide loans with higher interest rates, especially as the benchmark interest rate remains low. Together, these trends have resulted in a boom in auto lending, especially subprime loans to higher-risk borrowers, which have higher than average interest rates.

And, much like the housing bubble, as banks, private equity firms and credit unions compete, they have been extending loan terms to ever riskier borrowers. They have done so by extending the length of the loans, which brings monthly payments down to affordable levels, but creates a long-term equity trap that borrowers can get stuck in.

What have the consequences of this sub-prime lending been?

Many people who bought cars they couldn’t afford are suffering. Roughly six million auto borrowers with low credit scores are at least 90 days late on making their loan payments, according to new figures released by the New York Federal Reserve. That is the highest level of delinquent subprime auto loans we have seen since 2010. And remember, this is in a period of strong economic growth and wage growth. For perspective, in the depths of the recession, in the second quarter of 2009, that rate hit 2.4 percent.

This caused policymakers and economists to fear that when the economy dips into another recession, the already large number of Americans on the verge of losing their cars to repossession could swell to record levels because so many more people have subprime auto loans than in 2009.

If these loans are that risky, and people are defaulting on their loans, why do lenders make the loans?

One of the main reasons that lenders continue to make these loans is because they believe they are more secure than other loans for a couple of reasons. First, most Americans rely on their car to go about their daily life, including getting to and from their jobs. Because of this, most people will prioritize their car payments over other spending. On top of that, repossessing a car is much easier than foreclosing on a house or getting someone to pay their credit card bill. They simply pick up the car, and sell it to someone else.

Do you have rules of thumb we can use to avoid getting caught up in these loans, even if we have less than stellar credit?

A few things stand out. First, consider whether you need a new car in the first place. If your current car does the job and doesn’t cost you much in repairs, you could very well be better off sticking with it while you save money. If you do need a car but you have a lower credit score, pick your lender carefully. Not all subprime lenders are created equal, and some are more consumer-friendly than others. You want to avoid subprime financing companies if possible. Give your local bank or credit union a chance to finance a loan first. They may have options.

And if they do give you a loan, you can use it as a bargaining chip with the dealership, who may be willing to beat their terms. Third, if you have to buy a car, try to buy a new one rather than a used one. While you might think only about the sticker price, interest rates on used cars tend to be significantly higher, and they have already lost much of their value, meaning you could get underwater on that loan quickly. And most importantly, don’t buy a car you can’t afford. You can’t afford it if you will not be able to pay it off in under five years. Remember, automobiles lose roughly 13 percent of their value annually, so any loan over 5 years puts you at risk of reaching a point where you owe more than the car is worth.

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