Vehicle loans are some of the most popular products that banks will sell to personal consumers. However, because of the way in which a vehicle is such a major purchase for these clients, it is important for borrowers to understand exactly how it is that the banks are lending them these funds, and on what terms they have been exposed to the risks of borrowing. Specifically, by taking on a time planned personal loan against a vehicle, a consumer should recognize that they are exposed to interest rates, collateral values, and timing risks.
The first mistake that many consumers make in financing the vehicle through a bank is by making the assumption that their vehicle, as collateral, is worth as much as the price it was purchased for brand new. Unfortunately, vehicles depreciate by as much as 50% as soon as they are considered to be used. This means that, as soon as the vehicle has been taken off the lot as a new purchase, it instantly loses as much as 50% of its resale value.
From the bank’s perspective, this means that the vehicle as collateral only provides a 50% security against the value of the loan itself. This is why quite a few banks will require a down-payment on the purchase, in order to compensate for the lack of security in the purchase. Essentially, this means that not many banks will loan a consumer the full amount of funds required to purchase a brand new vehicle, unless they have a respectable credit score, income, and a working relationship with the bank.
The second aspect of vehicle lending that is important to take into consideration as a consumer is the fact that the collateral value of a car is extremely volatile. This means that the value of a new vehicle can instantly decrease to $0.00 in the event of a major collision, theft, or in the event that the vehicle breaks down. These sorts of situations leave a borrower in a tough situation, because of the way in which the bank still holds them responsible for the debt, even though the value of the collateral is now nonexistent.
What’s worse, now that the value of the collateral is null, the bank may require that the borrower either post additional collateral to cover the value of the principle, or repay the loan in full and with interest immediately.
When evaluating the risk of a vehicle loan from the perspective of a financial institution, as unstable as such an agreement may seem, a consumer has available to them some fairly effective products for ensuring that they are protected against the unforeseeable risks associated with the purchase. The most popular of these strategies is to pursue Property Insurance. By insuring the value of the vehicle against theft, damage, and collision, the consumer is effectively eliminating these risks from their loan portfolio. In many situations, the bank will actually decrease the interest rate charged to the loan itself in order to compensate for the decreased risk associated with the loan.
In all of these agreements, a third party agrees to cover the value of the vehicle loan in the event of unforeseeable damage or theft, in a way that indemnifies the consumer. This means that if the consumer were to crash their car, damaging it to the point at which it is no longer of value, the insurance company will cover the value of the loan, therefore protecting both the consumer’s finances and their credit score.