Study: Auto Loans For American-Made Cars More Likely To Default
UNIVERSITY PARK, PA (August 7, 2007) – New research co-authored by a professor at Penn State's Smeal College of Business could change the way banks assign interest rates to auto loans based on the make of the car being financed.
In a forthcoming book chapter, Brent Ambrose, professor of real estate at Smeal, and his co-authors find that the probability that borrowers will default on their auto loans is affected by the type of car that is financed. Loans secured for European cars and Japanese cars are 50 percent and 56 percent, respectively, less likely to default than loans on American cars.
The authors looked at the performance of 6,996 auto loans from January 1998 to March 2003. In addition to the probability of default being higher for American cars, their results show that loans on European cars are the least likely to be prepaid, followed by loans for Japanese makes.
The authors suggest that, just as insurance companies base rates on the make and model of the car being insured, banks should consider dropping their "house rates" for auto loans and adjust interest rates according the type of car being financed.
"Insurers have long recognized that automobile makes and models appeal to different clienteles, and that these clienteles have heterogeneous risk profiles and accident rates," they write. "Our results provide evidence that the type of automobile a consumer purchases reveals information about the consumer's propensity to prepay or default on the loan used to finance that purchase. Since the information on the type of automobile purchased is available to the lender at the point of origination … lenders could profitably pursue risk-based pricing based on the type of car the borrower purchases."
The findings in the study suggest that loans on "American cars should have significantly higher interest rates to compensate for higher default risk." To balance for this higher risk, American automobile manufacturers must price their products higher, which implies that "cash purchasers of American cars are, in effect, subsidizing the poor credit performance of buyers who finance the purchase of American cars."
As a result, there should be more cash purchases of European and Japanese cars where the purchase price does not incorporate the expected loss in the loan pool, and prior research shows to be the case.
This new research also shows that factors traditionally used to predict loan default and prepayment continue to perform as expected: A lower credit risk lowers the likelihood of default and increases the probability of prepayment, an increase in the loan-to-value ratio increases the risk of default and lowers the likelihood of prepayment, an increase in borrower income raises the probability of prepayment, an increase in local-area unemployment raises the likelihood of default, and a decrease in the market interest rate increases the probability of default and prepayment.
Some other findings in the research include:
• Loans for European and Japanese cars had a lower default rate (2.9 percent) than loans for American cars (4.7 percent).
• Loans for Saturns had default hazards 22 times higher than the default hazard of Toyotas.
• Loans for Mazdas were six times more likely to default than loans for Toyotas.
• Purchasers of American cars were older (45 years versus 41 and 38 for purchasers of European and Japanese cars, respectively).
• Purchasers of American cars borrowed more relative to the purchase price (80 percent versus 65 percent and 76 percent for purchasers of European and Japanese cars, respectively).
• European car purchasers had higher monthly incomes on average ($4,625) than either American ($4,024) or Japanese ($4,114) car purchasers.
"Asymmetric Information and the Automobile Loan Market" is a chapter in the forthcoming book Household Credit Usage: Personal Debt and Mortgages, published by Palgrave Macmillan and edited by Ambrose and Sumit Agarwal, financial economist at the Federal Reserve Bank of Chicago. The chapter is authored by Agarwal, Ambrose, and Souphala Chomsisengphet of the U.S. Office of the Comptroller of the Currency, Risk Analysis Division.
For more on the book, visit www.palgrave-usa.com/catalog/product.aspx?isbn=1403983925.