I have used this space on several occasions to offer insights into the recent evolution of consumer debt dynamics in the Canadian automotive retail market. Though the details varied, the theme did not: consumers have piled on more debt in the past decade to finance new vehicle purchases, but daily warnings that this would presage the death of the industry have been wildly exaggerated. I remain of the view that some of the more extreme warnings we’ve seen on the much-talked-about consumer debt story are not credible.
It is possible however, that the way in which debt dynamics have evolved in recent years could be storing up problems for our industry down the road.
Starting with the good news, new car sales remain well on pace for another record year in 2014. After record sales in 2013, the market didn’t need to grow by much to repeat the trick this year. As of this writing, sales are strongly ahead of last year’s pace and barring a very large contraction in the last quarter of the year we will establish a new sales record this year, possibly in excess of 1.8 million units. This is a remarkable turnaround and an indicator of a solid economy and confident consumers.
As has been the case for longer than this columnist has been around, the large majority of these sales need to be at least partially financed. Though most consumers do put some “skin in the game” with a down payment, the large-ticket nature of a new vehicle purchase means that close to 90 per cent of dealer customers need a financial product of some sort to cover most of the transaction.
A SMALL SLICE
Though leasing has returned from post-recession lows, it represents only about one-in-five new car transactions in Canada. This means that around two thirds of sales are purchases that are financed through conventional consumer loans.
The worrying trend in auto financing that’s given rise to warnings from economists and government officials is the habit of manufacturers, dealers and consumers alike to stretch purchase loans out for as long as possible. What was once an industry norm of four to five-year loan terms has nearly doubled to seven and even eight-year terms on what is universally recognized as a depreciating consumer good.
Some of this can be explained by improvements in product quality and lengthening vehicle lifespans. As a financed vehicle lasts longer than in the past, it is normal to amortize the loan that it backs over a slightly longer term. As an industry however, we have to face the reality that the majority of recent extensions in consumer loan terms have come as a result of insatiable consumer demand for the lowest possible monthly payment. Easy money and low rates have made this possible, but potentially at the cost of future sales. Consumers are increasingly buying a monthly payment and not a purchase price.
The longer a finance term lasts, the more time it takes for the consumer to be “above water” on the vehicle: to own more equity than the balance of the loan. At the extreme end of the scale, a zero per cent 96-month term turns a $25,000 purchase price into a $260 monthly payment.
THE DESIRABILITY FACTOR
However, since new vehicle depreciation is top heavy — quick in the early years of the car’s life and slower as it ages — it may take five years or even more for the customer to attain positive equity in the vehicle. Though depreciation is top-heavy, loan payments are not: they stay the same from one month to the next, whether that’s 72, 84 or 96 months. Consumers driving into dealerships with negative equity in their existing vehicles are not as desirable as those with positive trade in value for obvious reasons.
Up until now we have avoided any negative consequences coming from the trend to ever-longer loan terms. But past performance is no predictor of future results and though many of the analyses of this issue are fraught with extreme warnings, it is wise at least to consider the potential impact of the proliferation of negative equity and longer loan terms on future sales.
Average loan terms are not likely to get a lot longer than they are now. If this is true and we are near the limits of the degree to which finance products can be extended, problems could be stored up for future years, and we may be cashing in on today’s trends at the expense of long term prosperity.
