Aug 14, 2024
Is your institution adjusting its approach to the requirements of modern automotive lending?
The fundamentals of lending – liquidity, yield, credit risk, and cost of funds – remain unchanged and are still critical drivers and measures of success. However, new fundamentals have emerged that every lender should consider just as important in evaluating their auto lending practices and outcomes.
In March of 2022, the first of 11 consecutive rate increases by the Federal Reserve reawakened scrutiny on lending. As inflation remains stubbornly high and savings from COVID have all but evaporated, the focus has rightly shifted to the ongoing ability of consumers to service their existing debt and take on new loans. In automotive finance, higher borrowing costs and increasing auto loan delinquencies and defaults converged just as dealer inventory levels were beginning to recover.
As if automotive lenders needed even more to contend with, their business leaders are also increasingly challenged with how to properly utilize the growing deluge of data and emerging tools like AI. Exhausted yet? Where to start? What now?
As expectations from consumers, dealers, regulators, and shareholders rise, one conclusion can’t be escaped: The fundamentals of auto lending have changed. Here are four new fundamentals for auto lending and how data and technology can enable them.
Fundamental 1: Fast
Consumers and dealers no longer view fast decisioning as either too risky or “nice to have,” or even a differentiator. Fast decisioning needs to happen. There is even evidence that moving slowly can be harmful. Data obtained from Open Lending’s 2024 Lending Enablement Benchmark Survey found that lenders who take hours or days to return offers saw a greater increase in prime and super prime delinquencies than lenders who approved in seconds and minutes. In the same survey, lenders with longer approval processes were twice as likely to require rerunning the application to handle a counter on previously declined applications.
So, to be clear, having your underwriting team spend more time on an open application can yield higher levels of delinquencies, especially in applications that were initially scored as prime or super prime.
From a consumer’s perspective, the financing process has historically been considered the most time-consuming and least-satisfying part of the car-buying experience. Lenders have traditionally set rate sheets to speed up the loan pricing and approval process and meet consumer expectations for a fast decisioning. However, the rise in delinquencies and defaults we’re seeing now is equal to levels last seen during the Great Recession, which should serve as an alarm that something is wrong with the rate sheet status quo.
So, how can automotive lenders provide fast, accurate decisioning that meets consumer expectations? Using more data, including alternative data, optimized by an AI platform and coupled with human knowledge, will allow the industry to move faster. This coupling should be viewed as “actual intelligence” – the application of more data into a mysterious AI platform alone is not the answer. It’s the combination of advanced platforms, which Open Lending refers to as “Lending Enablement Solutions,” that can make speed and accuracy a reality.
Fundamental 2: Fair
Accurately identifying creditworthiness, especially among consumers in lower credit tiers, is critical for lenders and borrowers and something Open Lending has fostered since our founding. Fortunately, more lenders are looking beyond the traditional evaluation tools like credit scores to get a complete view of a borrower’s creditworthiness and profile. Still, how can we be sure this is a new fundamental and not a risky trend? Fair is table stakes. In the words of Yoda, “Do or do not. There is no try.”
The challenge is to be fair and accurate. Regulators expect fair treatment, but that’s not a reason to deprioritize discerning risk. Anyone who advises simply rescoring an application in the name of being fair should be viewed with great caution.
Incorporating alternative data to augment the traditional credit score is the beginning, not the end. The new way forward is to approach deal structure and loan pricing commensurate with the modeled risk of the deal, not just the consumer. The good news is that combining alternative data with evaluating the deal parameters grants entry into the near- and non-prime space, which allows lenders to serve historically overlooked but still creditworthy borrowers.
According to the Urban Institute, majority-Black communities and majority–Native American communities have the lowest median credit scores and the highest debt-in-collection rates and subprime credit score rates.
As lenders look to demonstrate fairness in lending, extending credit to near- and non-prime applicants will further enable lending to borrowers who have historically been excluded.
Fundamental 3: Flexible
Incorporating a flexible approach in auto lending should be viewed in two ways.
First, retain the flexibility to structure and price loans that address your institution’s needs and the realities of your market. Embed cost of funds and loan servicing, targeting ROA yields and competitive rates into your decisioning process and technology.
Second, as deals move to an accepted offer and booked loans, ensure your approval process provides the dealer and consumer flexibility. The payoff on pre-existing auto loans, trade-in valuations, cash down from the consumer, qualification for OEM incentives, vehicle availability, and price may all evolve as the deal does. Ensure modifying in any one of these areas doesn’t restart the process either within your underwriting team or in terms of needing to resubmit the deal and application for approval. Having to start over again would only work in opposition to the first fundamental mentioned: Being fast.
Fundamental 4: Flawless
You should be able to forecast yields and expected losses with great accuracy. While the industry has grown accustomed to using rate cards, it’s worth asking if they deliver the intended value. Within the lending institution and with the dealers who that institution supports in indirect lending, the simplicity of the rate card allows speed and certainty on what will be offered for a set credit score. However, the rate card also masks downside risk and, to some extent, prevents even more attractive rates on the upside.
Combining the analytics required to assess each application with a decisioning engine would deliver risk-based pricing that fulfills the need for a fast response and replaces the certainty of the rate with the certainty of pricing appropriately for the risk.
Alternative data and Lending Enablement Solutions that transform that data into a fully structured, risk-based price for each application and deal will deliver far more accurate and forecastable results.
Capture More Value and Serve More Consumers with Lending Enablement Solutions
It’s time the automotive lending industry embraced this market’s new fundamentals. These are the new standards for serving borrowers, meeting their expectations, and improving ROA. However, to master these fundamentals, lenders must implement Lending Enablement Solutions.
By incorporating a Lending Enablement Solution into your auto lending process, you can accelerate decisioning, identify and serve creditworthy borrowers who have previously been overlooked, establish a nimbler approval process, and improve accuracy.
Open Lending’s Lenders Protection™ has empowered hundreds of financial institutions to diversify their auto lending profiles, serve more near- and non-prime consumers, manage risk and earn higher yields. Contact us today to see how we can enhance your auto lending process.
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