Navigating a shifting auto lending landscape
Auto lenders face several interesting trends in 2018. On one hand, vehicle sales are expected to be robust with Cox Automotive projecting 39.5 million used vehicles to be sold up from 39.3 million and 16.7 million new vehicles down slightly from 17.1 million. U.S. consumer confidence is at a 17-year high and it is anticipated that the recent tax cuts will serve to fuel the economy and vehicle buying.
On the flip side, there are some risks, including the fact that interest rates are going up. There were three rate hikes in 2017 after almost a decade of interest rates near zero. In 2018, it is expected that the U.S. Federal Reserve will steadily increase interest rates given the state of the economy. While there is no crystal ball, those rates may go up more frequently if the economy ignites and inflation starts to increase.
At the same time as interest rates are going up, vehicles are more expensive than ever, given new features, technology, and the strong demand for SUVs and crossovers. According to Kelley Blue Book, the estimated average transaction price for a light vehicle in the U.S. was $36,270 in January 2018, up 3.9 percent from the same time last year. At the high end, a luxury full size SUV/crossover can reach up to $83,527 depending on options and packages.
According to Edmunds.com and the Wall Street Journal, average monthly payments now exceed $525 per month. This could also go higher given the recent steel tariffs that could be passed on from manufacturers to consumers.
Another factor the Cox Automotive 2018 Market Report brings to light is that share of total sales from residual-based financing (leasing and walk-away balloon lending) has grown to nearly 25 percent as of 2017. Residual-based financing’s record volume for the last five years has produced a number of desirable off-lease vehicles, those with Bluetooth and technology features, creating an option for certified pre-owned (CPO) buyers who find the new cars prohibitively expensive.
These trends create challenges and opportunities for auto lenders to offer consumers smart, low payment financing options that fit with their budget.
Approaching the challenge
In 2017, more than 85 percent of new car buyers and more than half of used car buyers used some type of financing. With the Federal Reserve forecasting three rate hikes in 2018, many are concerned that the credit available to fuel demand growth could be impacted. Here are a couple of paths to approach the challenge.
Path A: Extending Terms
Given these trends, lenders are increasingly extending terms in order for consumers to have a lower, feasible monthly payment. Credit unions are extending terms to 84 months to 96 months to lower the payment within the consumer’s range. Unfortunately, extended terms have led to record negative equity for the consumer. Average loan maturity grew from 62.4 months in Q3 2008 to 66.5 months in 2017. In the first quarter of 2017, the percentage of trade-ins on new-vehicle sales that had negative equity reached a record 32.8 percent. The average amount of negative equity, at $5,195, was also an all-time high, according to data from Edmunds.
Path B: Residual Based Financing
Leasing has long been the financing alternative for consumers who want to switch cars more frequently. Leasing offers lower monthly payments, with the option to walk away and turn the vehicle in at the end of the term. In some states, sales tax is calculated on the monthly payment (instead of paying it up front) which may reduce the payment further. The captives are the primary financing sources for new vehicle leases, but they rarely offer leasing for used vehicles. Given the forecasted increase for used cars in 2018, offering a payment alternative for used vehicles would be a competitive advantage for a financial institution. The vehicle title is held by the lessor (typically the financing source). This title scenario can trigger additional sales taxes if the consumer decides to purchase the vehicle at the end of the term. This type of financing is only used in an indirect lending environment.
A smart alternative is to offer residual-based “walk-away” balloon financing. Rather than extending terms, this allows a credit union to offer members lower monthly payments and a guarantee of the residual value. It is different than what is normally understood as a balloon loan. The borrower owner benefits because the vehicle is titled in their name, giving them more options prior to the loan maturity. There is no down payment and no prepayment penalties with this type of program and several options during or at the end of the term including: refinancing the remaining balance and keeping the vehicle, selling the vehicle privately, paying the balance in full and keeping the vehicle, trading it into the dealer, or surrendering the vehicle in lieu of a final balloon payment.
Financial institutions can take advantage of prepackaged white-label programs to be able to offer this type of financing in order to expand their loan portfolio with minimal operational effort. Such a program also allows dealers in the financial institution’s indirect channel to advertise a low monthly payment, which helps to increase showroom traffic.
In addition to indirect lending, walk-away balloon financing can also be used in direct lending. Some institutions have even offered these loans to borrowers at risk for delinquency to lower their payment and help them stay in the loan. Additional advantages of walk-away balloon financing are that it is not only available for new car purchases, but also for used vehicle sales and can be leveraged by the financial institution as a loan re-capture program.
Expanding the auto lending portfolio
The outlook is positive for used and new car sales, but lenders would be wise to take steps to capitalize on the opportunity by providing consumers with friendly financing alternatives. The residual-based financing scenarios are a win-win for the consumer and lender. The consumer can lower payments and experience lower risk working with a financial institution that they trust; the lender can increase loan volume and experience higher yields. As Cox Automotive adeptly assessed, the market outlook is rosy, but credit unions and financial institutions must rise to the occasion to help their members and consumers get into the car of their dreams – affordably and responsibly.