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.