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Will car loans create the next "subprime lending" crisis?

Massachusetts residents have probably heard that "subprime lending" in the housing market significantly contributed to the onset of the 2008 Great Recession. Now, some are concerned that history is repeating itself in the world of consumer automobile financing.

By way of background, subprime lending occurs when financial institutions loan money to people with limited income or who are, traditionally, not thought of as good credit risks. The advantage to subprime lending is that it offers a second chance, much like bankruptcy does, to people who otherwise could not get a loan to purchase what they want or even need.

From a financial standpoint, a subprime lender takes on an extra risk that the borrower will not repay his or her loan, leaving the lender with a loss. The financial institution must compensate for this risk somehow. In the case of subprime auto loans, this means low down payments but very high interest rates.

While a consumer may be willing and able to pay off these auto loans even at a high interest rate during good financial times, this system can prove unworkable for an average person should he or she suddenly be faced with financial struggles like losing a job or suffering a medical emergency. The interest on the car loan can become overwhelming and leave the car owner with serious debt relief needs.

Fortunately, filing for bankruptcy can help a person with changed circumstances obtain debt relief and, in some cases, keep his or her vehicle from being repossessed. In some situations when a person files for Chapter 13 bankruptcy, he or she may be able to do what is called "cramming down" a car loan by repaying the present market value of the car rather than the car's original purchase price. While certainly not the best outcome for a lender, this practice can help a consumer salvage a high interest subprime loan and make the most of a bad situation.

Source: The Macomb Daily, "How the Fed fueled an explosion in subprime auto loans," July 9, 2013