Credit approval standards have been loose the last few years, but that is changing.
Over the next twelve months, we predict an upward shift in credit tiers. This will be particularly impactful among the near-prime tier, those who are currently 18.2% of all borrowers. This segments’ credit makes them fall short of traditional lending requirements. However, if credit requirements shift in their favor, a current near-prime borrower really could be considered an emerging prime borrower.
Is credit too expensive for the near prime borrower?
As the economy rebounds from the pandemic, the near-prime segment continues to grow in numbers year over year. These borrowers may be riskier for many lenders due to their low or weak credit, limited credit history, low credit scores, higher income-to-debt ratios, and/or unstable employment history. Regardless of what criteria makes credit too expensive or inaccessible for them, they have this in common: They need vehicles, reliable vehicles they can afford.
For this group, vehicles are a means to generate income, allowing them to pay their bills. A person that has a reliable vehicle for transportation won’t have to turn down a promotion at work, can maintain a quality of life, and contribute to society in more ways than if they weren’t vehicle owners. Yet, 25% of the $75,000-$100,000 salary bracket believe that car ownership is a pipedream.
If near-prime borrowers are not approved for a loan on a reliable vehicle, they may be stuck with an older vehicle in disrepair, and revert to credit cards for repairs, creating an ongoing cycle of financial strain and stress.
There is growing emphasis on how to serve a generally underserved population of borrowers, and financial institutions have unique opportunities to serve this credit segment with mitigated risk. Lenders and borrowers alike need the tools for economic resilience. Here are our top five strategies to accomplish this:
5 Strategies to Serve Near-Prime Borrowers
- Keep fairness at the forefront.
Empowering borrowers is the name of the auto lending game, even for risker, underserved borrowers. The CFPB has hawk eyes on borrower sensitivity these days, with the update of Reg B (Equal Credit Opportunity Act) and recent data pointing to near-prime borrower migrating into a prime or better tier within 12 months.
Keep borrower fairness at the forefront of lending decisions by being transparent from sale to closing. Be honest throughout the process about all fees involved in an auto loan and monthly payment.
- Look beyond FICO.
Delinquencies are rising among all credit levels, yet 52% of applicants are denied an auto loan because of their credit score. A recent Open Lending study revealed that near-prime borrowers make up 13% less delinquencies than prime borrowers, showing that FICO scores are not the only factor of future risk. If the FICO score is solely used to determine approvals, there may be low risk borrowers who fall through the cracks and miss out on credit opportunities. For example, a borrower may be evaluated as near-prime at the time of loan approval, but this doesn’t consider how their credit health might strengthen over the lifecycle of the loan.
What if there are other risk indicators that could be used in conjunction with a credit score to determine credit worthiness? Leveraging advanced data analytics can help decision makers look beyond the FICO score and get a holistic look at each borrower’s unique risk level.
- Follow the data map.
Imagine you’re following your GPS to a new destination and suddenly you lose cell coverage. Your car isn’t stashed with a paper map these days and your only hope of arriving at your destination on time is that your cell coverage returns before the next fork in the road. Data analytics are like that GPS, giving guidance and confident decision-making power for the economic forks in the road. Manual processes or data cannot offer the speed and accuracy needed for transparency and full risk mitigation. The right data at the right time quickly calculates to structure and price the deal, and offer risk-level appropriate coverage.
Advanced analytics and integrations automate the decisioning, provide a risk score and recommended structure and pricing for auto loans, and incorporate default insurance can help lenders hedge against losses and strike a better balance between prime and near-prime consumers.
- Don’t put your balance sheet at risk.
To prevent balance sheet imbalance, it’s natural to tighten lending measures. But how much tightening is overtightening?
As we navigate an uncertain financial environment, auto lenders need to consider expanding their base of near-prime consumers, otherwise, downward pressure on yield will become an added challenge. Position your financial intuition as a strong player in the near-prime space with the right balance sheet approach to take on this segment.
Auto loan default insurance is a tool that allows financial institutions to safely lend to the near-prime market. Using sophisticated risk-based pricing models, a small interest fee is charged to the borrower in their loan payment. This coverage is miniscule to the borrower and provides a safety net to the lender in the event of loan default. This coverage lowers risk by mitigating deficiency while still allowing lenders to extend credit to this credit tier.
- Leverage loyalty.
There is an entire population of non-vehicle owners who believe that they are disqualified from vehicle ownership due to their credit standing. When your financial institution approves their loan, this unlocks the potential for a longer-term relationship with the borrower. Did you know that 83% of borrowers will bank with the financial institution that they have a positive auto loan experience with? Extending auto loans to an underserved market can ignite loyalty that creates a returning accountholder.
What Near-Prime Borrowers Really Need From FIs
Establishing a line of credit in the form of an auto loan is critical to a healthy, growing credit score. People need vehicles, regardless of their lifestyle or credit tier. Near-prime borrowers need a financial institution that looks beyond their current credit score to approve their vehicle financing, and they need access to the best auto loan that their risk status allows. Extending an auto loan to the right near-prime applicant can lay the financial groundwork for the prime consumer of tomorrow.
From a lending perspective, there’s a clear and immediate opportunity to better serve consumers across credit segments, empowering near and near-prime borrowers with vehicle access. It’s impossible to know what the next 12 months will hold. But it is possible to be prepared to provide credit to the typically underserved. With risk modeling tools and the right coverage to protect riskier loans, financial institutions can lend to near-prime borrowers and provide a soft landing for all.
Open Lending is a Champion partner with Allied Solutions.
About Open Lending
Open Lending (NASDAQ: LPRO) provides loan analytics, risk-based pricing, risk modeling and default insurance to auto lenders throughout the United States. Since the company’s inception in 2000, Open Lending has insured almost $20 billion in auto loans, allowing an institution to expand their loan offerings with lower credit scores, higher loan advances, longer loan terms, and competitive interest rates. For 20 years, Open Lending has been empowering financial institutions to create profitable auto loan portfolios with less risk and more reward. For more information, visit openlending.com.