Chicken Little told all of her friends that the sky was falling. But in the end, the story teaches us that there is more to every story than we hear.
In our earlier blog discussing the health of the auto finance industry, we spoke about longer loan terms and subprime versus deep subprime buyers. Let’s take a look at the third area of the auto finance industry, equity and interest rates.
Equity & Interest Rates
When you buy a house, it’s considered an investment. It should build equity and you should be able to sell it for more money decades from now, if you sell it at all. Of course, this didn’t happen when the housing market crashed. But trying to compare it to auto finance is apples and oranges.
When buying a car, it’s just the opposite of buying a house. Depreciation comes with the territory because cars simply don’t last as long as houses. You might be able to pass it along to your teenager, but it’s not going to last for 5 or more generations like a house would. Prime to deep subprime buyers know that even a brand new car starts losing value the moment it’s driven off the lot.
In addition to lost equity, subprime buyers typically see higher interest rates. And when the loan term is extended across 68 months, trading up in two years is not as simple and buyers are adjusting to this new structure – just like dealers and lenders are having to adjust to the risks associated with extended loans and the longer lead time needed to turn a profit on a sale.
Speaking of higher interest rates, they’re yet another reason why we’re not looking at a bubble that’s about to burst. Unlike the big banks and mortgage companies deemed “too big to fail”, smaller auto finance companies and BHPH dealers financing subprime paper can’t survive an avalanche of defaults.
By implementing an interest rate system based on credit worthiness, the auto finance industry is covering its own bets on subprime buyers. Higher rates lessen the increased risk and cost of defaults. For the BHPH market, it means the dealer will likely have the funds needed to recover, recondition and resell a vehicle or replenish lot inventory if the buyer stops making payments.
So, What Does This All Mean?
The doom and gloom types are insisting that the auto finance industry is being pushed to the breaking point due to a massive increase in subprime sales that come with higher interest rates and longer loan terms. And they’re erroneously comparing it to the housing market crash. While there may be parallels, these are entirely different industries.
Yes, more cars are being sold, but the overall percentage of subprime and deep subprime buyers isn’t skyrocketing. Dealers and finance companies are keeping a cool head.
Yes, extended loan terms are on the rise. By stretching out this timeline, millions of people who need cars are finally able to afford them and by keeping payments low, the vast majority will not default.
Yes, cars depreciate and higher interest rates make trading up a challenge. However, we’re seeing a lot of buyers pivot accordingly. They’re making steady payments in order to refinance at a better rate and swing the numbers in their favor. They’re paying off their loans faster. And many others are just happy to drive their cars until the wheels fall off. Trading in is not the end game for every buyer.
While defaults are inevitable, they’re nothing new for the auto finance industry. Before taking a risk on a subprime buyer, references and employment history are carefully vetted. GPS-based technology is often implemented to send payment reminders and track collateral. Loan companies and BHPH dealers are actually seeing an improvement in their businesses and profits these days.
Things are actually looking up – and what we’re seeing is that the sky is not falling.