Disruption and innovation in US auto financing

Dramatic changes have marked the US financial services industry over the last five to seven years. In the mortgage market, low-cost digital attackers have been gaining significant share, and retail payments have seen the emergence of buy-now, pay-later players. Auto financing, by contrast, has experienced relatively little disruption over the past decade.

This period of relative stability may be about to end. In the last 18 months, the industry has seen a sharp increase in demand. A diverse and expanding set of lenders—large banks, regional banks, online retailers, and fintechs—are considering moves into this asset class.

Incumbents in the auto-financing segment will continue to play a key role if they prepare for disruption. They should consider taking advantage of market tailwinds to increase origination and evaluating initiatives to improve profitability and establish greater dealer stickiness. Also, in the current uncertain economic environment, they will need to heighten their focus on delinquency rates.

Robust demand but disruption in store

US auto loan origination grew just 2 percent a year from 2016 to 2020, with indirect financing through dealership networks accounting for around three-quarters of total consumer financing volume. In 2021, demand spiked 20 percent, accompanied by a corresponding increase in used-vehicle prices (Exhibit 1). Meanwhile, high interest rates and limited housing inventory are presenting challenges to growth in other consumer asset classes, such as mortgages and unsecured lending.

Other factors are making auto financing more attractive. The used-car prime segment, for example, has become more addressable thanks to a combination of two factors: an increase in the consumer price index for used cars and trucks of 40 percent between January 2021 and July 2022 (due to supply shortages); and the ongoing upward credit migration of customers (Exhibit 2)—driven by continued economic expansion and by a gradual increase in sophistication across underwriting, fraud detection, and collection processes. Rental-car companies’ average fleet sizes also have played a role. In 2020, when pandemic-related shutdowns halted business and personal travel, several rental companies faced the threat of bankruptcy and were forced to liquidate their fleets. Then 2021’s relaxed travel restrictions led to a spike in rental-car demand and shortages of new-vehicle inventory, forcing companies to turn to used vehicles to replenish their fleets.

The value chain for auto purchase and ownership has transformed over the past few years, opening up new opportunities for financial services. Regional banks, online auto retailers (for example, Carvana and Vroom), and a number of fintechs (including AutoFi, AUTOPAY, and Caribou) are entering or have recently entered the space.

The rise in consumer demand is not the only attraction for lenders with portfolios of consumer asset classes. Particularly in the face of a potential recession, lenders may appreciate auto financing’s consistently low delinquencies (less than 3.5 percent) over the past two decades, including during the subprime debt crisis (Exhibit 4). Delinquencies have remained near all-time lows despite lingering unemployment, rising vehicle prices, and relatively higher inflation, in part because borrowers have leaned on financial-hardship programs that let them postpone loan payments. (Despite these conditions, the cushions that have protected this asset class may have begun to diminish.) Another draw for lenders is the average loan length of the asset class—roughly six years according to recent research, which is significantly shorter than the average mortgage.3 This shorter loan period offers protection against interest rate risk, which has increased with inflation.

New developments in US auto finance

Consumer financing of vehicles typically involves indirect financing through dealership networks, which accounts for 70 to 80 percent of total volume. Captive lenders and banks distribute multiple financing and insurance products to dealerships. Their products include consumer auto finance, warranty and payment-protection products (including white-labeled offers), and floor plan and commercial financing programs.4 Historically, some captive financing units and banks have taken a very siloed approach to distributing these products.

Now more lenders appear to be taking an integrated view of dealer coverage across the full suite of dealer offerings, supported by a comprehensive dealer-level scorecard. Amid rising interest rates, some aim to strengthen their relationships with dealers by taking a holistic approach to pricing that considers multiple components—for example, product pricing rates and fees, dealer compensation, existing programs, and their dealer rewards program. However, we have seen few examples of lenders that have fully succeeded with the approach of charging a premium in their pricing based on holistic dealer offering (Exhibit 5).

Meanwhile, auto retailers are more often making financing a core part of their go-to-market strategy. Asbury Automotive5  and AutoNation,6  for example, are exploring launching their own captive financing units, and Carvana’s financing arm has been its only bright spot amid debt-funding struggles.7 By offering loans, dealership networks can ensure consistent financing across their businesses.

To remain competitive, banks, captives, and other lenders are increasing their use of digital and analytics capabilities. For example, Capital One developed the Auto Navigator tool, which lets car shoppers search for cars and prequalify for financing without affecting their credit scores.8 AutoFi, which provides digital retail systems to car dealers, banks, OEMs, and online marketplaces, offers a cloud-based pricing platform called Real Payments that lets consumers prequalify for financing and see prices and monthly payments across vehicles within seconds. Further, GM has launched its own used-car online retailer, CarBravo, to compete with Vroom, and other online dealers.

Refinancing is increasing, led by fintechs. Fintech players are using partnerships to consolidate as much of the auto refinancing market as they can. Upstart, for instance, uses its own auto-lending performance data to power its auto-refinancing model.

Another growth area will be loans to purchase electric vehicles (EVs), given that electric vehicles’ (EV) share of car sales is growing at around 70 percent annually (Exhibit 6). Banks have dominated lending in the EV space so far, using indirect lending through dealers. We expect that captives will catch up soon with direct-to-consumer lending, as original equipment manufacturers transition to using direct-to-consumer EV distribution models.

What auto-financing lenders should do now

Competitors in the auto-financing segment should consider taking advantage of market tailwinds to increase origination. In addition, they could evaluate other initiatives to boost profitability and increase dealer stickiness.

Along with considering these actions, auto financing players should make strategic bets with an eye to the future, given that the market is expected to expand significantly over the next few years. Such bets might focus on financing charging infrastructure for electric vehicles, advanced recreational-vehicle modeling to improve the lifetime of EV batteries, and innovative pricing models, such as renting vehicles by the mile and other subscription models.

The auto-financing landscape has begun to shift. Now is an opportune time to reevaluate and update strategies and operating models. Lenders that act quickly can stay relevant and even increase their share of a changing market.