Bad Credit Car Finance Runs on Credit Rationing, Not Just Higher Interest Rates

The financial behaviour of UK sub-prime borrowers is a prime example of how bad credit affects the borrower's ability to obtain a loan to purchase a vehicle. The average finance rate charged to UK sub-prime borrowers is 24.2%. However, while this is a clearly high-cost finance option when compared to the low finance rate of a typical borrower, this figure does not encompass the actual average financial value of the finance markets available to the sub-prime segment. The Financial Conduct Authority confirmed that many lenders restrict the number of loans offered to sub-prime borrowers through the use of credit rationing rather than simply increasing the price for those loans. In essence, lenders use risk assessments to ascertain who is eligible to receive a loan based on their creditworthiness rather than solely using stated income as a method of appraisal.

In their research, Stiglitz and Weiss (1981) formulated a theoretical framework outlining the fundamental principles of credit rationing; the application of this theoretical framework can be easily mapped to the vehicle finance markets. The essence of their theoretical model hinges on the belief that lenders determine how much money is available to sub-prime borrowers based on a lender's risk assessment of the borrower's financial position. Therefore, if a sub-prime borrower is deemed by the lender to be at significant risk of defaulting on their finance contract, then the lender may restrict how much it will advance, or on what terms, rather than raising the price without limit. The way that lenders assess the risk of default is what matters most.

Some applicants are rejected before they even get to think about price.

According to the FCA's 2024 Financial Lives Survey, approximately 7% of adults in the UK who applied were completely rejected for motor finance at all. The credit score allows lenders to close the gap between their assessment and what a borrower's repayment history can show. Where the uncertainty remains too great, some lenders will decline the application instead of pricing it

Even if the price were raised higher, it would not resolve the risk issue.

In most industries, the market's supply and demand will determine what those prices are: if the price is pushed up enough (and demand continues to decline), then supply and demand will meet and production will be rationed accordingly. The car finance industry operates differently. The FCA notes in its own research that sub-prime borrowers are generally less affected by rising rates than prime borrowers because they typically have fewer options available, and they view high rates as more acceptable or necessary. Raising the price across the board would not provide a clear determinant of risk; instead, it would just increase the average cost of all borrowers with no other options.

This is the reason why specialist brokers work alongside mainstream lenders. If someone is turned down by a traditional lender, they can access car finance with bad credit through a broker who has access to a selection of specialist lenders willing to take on the added risk associated with that borrower, and in most cases, these lenders will require a larger deposit, a guarantor, and/or a higher rate. The way the credit market is rationed is not based purely on a rate but on a combination of conditions; the interest rate does not continue to climb indefinitely, but instead, it reduces the number of borrowers who qualify for financing and under what terms they can do so. Due to each lender establishing its own thresholds for what risk it will accept, two borrowers with the same credit score can still receive different offers from brokers based on the lenders in the broker's panel.

This does not mean that all bad-credit car finance products are "bad deals". A higher interest rate on a car loan may actually be a reasonable option for someone who needs a car to commute to work, and has no less costly means of doing so. However, the price of the car loan will always consist of only half of the whole; the deposit amount and the car loan provider's panel will have as much bearing on the cost to the borrower as will the APR.