While the ultra-low interest rates mentioned in car commercials certainly sound appealing, many potential buyers do not have the necessary credit history and credit score to qualify for these preferred rates. For these individuals, subprime auto loans are often the only method of obtaining the transportation that they so desperately need in order to work and provide for their families. Since these loans typically come with various fees and high interest rates that can have the effect of worsening an already precarious financial situation, it is important to have a clear understanding of the potential consequences before signing on the dotted line.

Portrait of a Typical Car Loan:

At the end of 2016, the average car loan amount was almost $31,000. “Well-qualified” buyers with credit scores above 780 had an average interest rate of 2.63 percent.

What Is a Subprime Car Loan?

As a general rule, subprime car loans are extended to those with credit scores in the low 600s. While traditional car loans have interest rates in the low single digits, the typical subprime loan to a borrower with a credit score of 600 averaged 10.71 percent during the fourth quarter of 2016. Subprime loans account for approximately 20 percent of the car loan market.

There are several reasons why lenders are willing to overlook a checkered credit history when approving car loans:

  • The vehicle serves as collateral for the loan. In the event of default, the lender can repossess the vehicle to recoup at least a portion of the debt. Technology is also making it easier for finance companies to track or even disable the vehicle if the borrower should default.
  • Subprime auto loans are often bundled and sold on the secondary debt market.
  • Car dealers are not subject to some of the same regulations as banks and credit unions, which allows subprime lenders to charge higher fees and interest.

True Cost of Ownership:

When purchasing a car, most borrowers are only concerned about the monthly payment amount; however, a number of other factors should be considered, especially when dealing with subprime loans:

  • A lower monthly payment may mean a longer payment term. This means that you could end up paying thousands more over the life of the loan. Some subprime loans even come with penalties for early payment. You also have to consider the current age and condition of the vehicle to make sure that it will even last until the end of the loan period.
  • Subprime lenders are compensated for their risk through fees. It is not unusual for fee amounts to vary widely from lender to lender, so it is imperative that you read the contract carefully to avoidt any unpleasant surprises.
  • Be realistic about your budget and your ability to repay the loan. It is always better to go for a modest, functional vehicle over one that will leave you stressed and struggling to make the payment each month.
  • If you have credit challenges, you will most likely have to look to an online lender or the dealer for your loan. If shopping online, be sure to check multiple lenders to get the best terms. If going through a dealer, remember that the dealer is looking for the most favorable loan option for them, not you.
  • You should not automatically rule out traditional lenders even though you may have less than perfect credit. You do not want to be saddled with a high-interest/high-fee loan only to find out you could have received more favorable terms from your local bank. You simply have to be willing to move on if you get turned down.

The Bottom Line:

While a subprime auto loan may be a viable option if you have no other way to meet your work, school, or family obligations, they should not be used to achieve instant gratification. Whenever possible, you should try to delay the purchase until you can save money for a down payment, reduce your monthly expenses, and improve your credit score.