The Double-Edged Sword
Long-term loan products are poised to replace lease offerings for customers seeking low monthly payments on their automobiles. But 72- and 84-month loans may create a new set of problems for the industry as lenders face a surge of negative equity among their borrowers.
In auto finance, “negative equity” occurs when a borrower owes more on his vehicle than it is worth. This scenario is also referred to as being “upside-down” on the loan.
Inherently, the longer the loan term the greater the chance of delinquency or default. With a five-year loan, a consumer has 60 chances to miss a payment; with a seven-year loan, those chances increase by 40%, to 84.
Another problem with longer-term loans involves the odds that a vehicle suffers a mechanical breakdown — another factor that could send delinquencies higher.
To my mind, six- and seven-year loans are a lot like the 40- and 50-year mortgages that became popular just before the subprime debacle last year. The difference in payment on a five-year auto loan and a seven-year auto loan is relatively small — much smaller than the risk of default the lender assumes by underwriting the loan.
Take this example: On a $15,000, five-year loan with an 8% interest, the monthly payment would be $304.15. On a seven-year loan with the same characteristics, the monthly payment would be $233.79. The difference is only $70 a month. But the borrower is on the hook for an added 24 months — and $1,400 in interest.
It seems that the solution is a stronger push to get consumers into cars they can actually afford, as opposed to those they must stretch to acquire. Lenders should reduce reliance on longer-term loans, just as they’ve done with leasing; if not, we may see a repeat of the current auto finance crisis much sooner than we’d like.
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Yes, I do think the shift will be to used…although as with economics a surge in demand counters with a surge in price. Case in point, a 1994 Geo Metro was selling two years ago for $1,200 now sells as high as $6,000 with 150,000 miles. Now much of that is due to its exceptional gas mileage but you can definately see some upticks.
The best way to combat ever increasing finance terms is for the captive financiers to better manage the customer purchase cycle. The very best way to achieve this is via closed end leasing contracts or PCP’s as we refer to them in the UK. Closed end leasing products ideally over a 2 or 3 year term (using small downpayments) offer the very best opportunity for oem finance companies in tandem with their retail networks to maximise on customer renewal and retention. If finance products such as closed end lease programmes are designed sensibly by the captives in partnership with their respective oem’s the customer retailer, financier and oem all benefit. The added value that this type of finance product provides to the consumer means by definition that it does not have to necessarily equate to a low payment product. It simply has to represent good value and be presented expertly by staff in dealer at POS.
But Paul, how do U.K. financiers avoid residual value losses? Even if the lease is only two or three years, the potential exists for inaccurate residuals. In fact, the bulk of a vehicle’s depreciation occurs in the first couple years, so it’s not like writing a shorter lease will eliminate the problem.
The answer is pretty straight forward. Financiers have to set sensible residuals. Most usually in the UK closed end lease residuals are set a few points lower that contract hire product. As I said in my initial comment, it’s all about being sensible with R/V’s. If financiers want to buy business by setting unrealistic residuals then they will enjoy short term gain and put metal on the street. However mid to long term stability in the leasing business comes from setting realistic residuals. Orderly marketing, sensible pricing and realistic R/V’s all in all Good old fashioned business…
I agree that the government is squashing the rights of the dealers. There will be no way to get a fair decision in the appeals.