I’m going to start and end this blog post with a question: Why are there no adjustable-rate auto loans? Is the idea that ridiculous? (Ok, I’ll start it with two questions.)
Car loan terms have increased significantly during the past 40 years. When the Federal Reserve started tracking auto loan terms in 1971, the average maturity was 35 months. Since then, the average car loan has stretched to 62 months, according to the Federal Reserve. Five years is a long time. It’s the equivalent of a complete economic cycle.
One of the primary benefits of adjustable-rate loans is that they offer a natural interest-rate hedge for the lender. If interest rates move too far one way or the other, borrowers may be more likely to walk away from a loan, especially if they can get a better deal.
Interest rates serve several purposes. They act as a risk-management tool for borrowers who are more likely to default. They also act to cover the cost a lender incurs to borrow the money that gets lent out for the car loan. They also act as a profit margin. There is also a risk for most financial institutions, which fund loans from deposits made by consumers. Deposit interest rates fluctuate based on the credit and capital markets. Banks run the risk of losing money by offering too many fixed-rate car loans at a certain rate, only to see the rate they need to pay to gain deposits increase.
By introducing an adjustable-rate car loan, lenders would be able to price their products more competitively, without worrying how interest rates are going to move in the future.
Credit card rates fluctuate. Mortgage interest rates fluctuate. Yes, auto loans are a different asset class. But are they so different that the interest rate on the loans used to purchase automobiles can’t fluctuate, too?
There are adjustable rate auto loans in Canada today that seem to be somewhat popular. From my perspective, that as much as the make sense from a lender perspective, not sure if in today’s interest rate environment if it makes much sense to the consumer? Rates are already super low so there seems to be only down side risk to the consumer. In a declining interest environment, I think consumers would love adjustable rate programs for auto loans.
I tried adjustable rate auto loans in the mid 1980’s as a protection from the disasterous rate changes of 1980. Offered as an option, and no-one took it up. Most folks only want the front end low teaser rates on adjustable products, they don’t want the higher rates as time goes by. Often they can’t afford those rates – they maxed out their purchase based on the low rate. Adjustable rates make sense, but the market place won’t move there unless they know they are on the high end, or unless there are no other options. Maybe the times have changed – but I don’t see evidence of it.
Marcie Belles posted a blog the other day that highlighted the payment deferrals that some lenders are offering to graduates. If these are such a popular product, it would seem that low teaser rates would also garner interest. Maybe the possibility of higher payments down the road might scare some consumers off, but from all I have learned and read it seems as though consumers don’t necessarily look that far ahead when making these kinds of decisions.
1) The public has alreay been “abused” by adjustable rate mortgages. Why would they trust any bank that offered an adjustable rate auto loan?
2) At the major banks, the auto finance staff are often viewed as “second class bankers” and why would the upper class treasury managment staff want to work hard to create a product for them?
3) We are losing the middle class in America and there is great uncertainty in making any regular payment. An adjustible rate adds more uncertainty to the lives of the lower middle class.
4) Finally, the negative convexity of a fixed rate loan in a rapidly moving upward rate environment, is a disincentive to trade-in your still financed car to buy another at a much higher interest rate.
The author notes the lengthening term of auto loans.
How would / should a lender evaluate capacity when the variability of the monthly payment introduces an additional variable?
As mentioned before, marketability of a product that leaves significant room for periodic payment increases is questionable. So, in practice, such a product would likely end up offering the most vehicle possible (high cap cost) based on the spot rate / payment, maxing out the borrower’s capacity. Unless borrower wages move up with increasing interest rates, a squeeze against capacity is likely.
“Protection” against higher rates for the lender is only helpful if borrower can make the higher payments.