Option value and auto title loans

Michael H. Anderson and Raymond Jackson

Journal of Economics and Business, 2021, vol. 117, issue C, No S0148619521000266

Abstract: A title loan is a short- term subprime loan secured by the title of the borrower’s automobile. Upon repayment, the title is retrieved from the lender and the borrower retains the vehicle. In the event of default the lender keeps the title and takes possession of the automobile but has no further recourse if the sale of the auto does not satisfy the outstanding debt. In this paper the borrower’s repayment decision is modeled as a call option with a strike price and option value dependent on loan size and term, interest rate, auto value at expiration and a variable that has not received adequate attention – vehicle quality. Given asymmetric information, the borrower is cognizant as to whether the auto is a peach, lemon or non-fruit and this significantly affects the option value and repayment decision. Under certain conditions the option value of repayment is zero and default may be the better decision even for the owner of a peach. The model is extended to compare the value of the repayment option to the payout of the residual value received from the lender after default. The incentives to rollover the loan are also discussed in terms of the call option value. Analyses are presented of the implications, within the context of the option model, of the use of the auto as collateral and also the likely outcomes for title lenders. Structuring the repayment decision as a call option allows those developing public policy to examine the impact of regulating interest rates, loan term, the loan to auto value ratio and the minimum residual factor.

Keywords: Title loans; Consumer credit; Subprime lending; Real options; Asymmetric information (search for similar items in EconPapers)
Date: 2021
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Persistent link: https://EconPapers.repec.org/RePEc:eee:jebusi:v:117:y:2021:i:c:s0148619521000266

DOI: 10.1016/j.jeconbus.2021.106008

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