Some analysts are concerned many potential car owners could find themselves financially unable to buy new vehicles three-four years down the road.
Why? Because those customers unwittingly discover during trade-in talks at the dealership that they owe more on their current vehicles than the cars are worth.
That can scare a lot of them off the lot.
It's called being “upside down.” It has some industry people worried that there may be much dizziness in the future. The finger of blame is being pointed at today's aggressive incentives.
Why blame them? Here's the rationale:
As incentives make it easier for consumers to buy new vehicles today, they also are driving down the values of used vehicles. For example, a typical 2-year-old SUV decreases $500 in value for every $1,000 in incentives added to the current model, according to Power Information Network an affiliate of J.D. Power and Associates.
The Manheim Used Vehicle Value Index shows a 6.9% decline in year-over-year used-vehicle values.
As a result, an entire segment of car owners is being created who owe substantially more on their car loans than the vehicles are worth, making them “upside down” financially and, realistically, unlikely to buy anytime soon.
“There's no question that there is a larger percentage of the buying population that is in this situation today,” says Bill Krouse, vice president of Polar Chevrolet Mazda in White Bear Lake, MN.
Edmunds.com data shows 40% of new car buyers have negative equity in their vehicles. The average negative equity is $2,200.
Adding to depressed used-vehicle values are the longer loan terms being offered to car buyers. Some 84% of new vehicle loans originated in 2002 were for 49 months or longer, reports the Consumer Bankers Assn. Loans with terms extending five years and longer increased to 34% in 2002 — up from 21% in 2000.
Financing is becoming more popular as auto makers and lending institutions have pulled back from leasing after suffering huge residual losses in the age of incredibly low lease payments.
Attracted to those low rates of yesterday, many consumers leased upscale cars they otherwise couldn't afford to own.
To get those same customers into comparable vehicles today, longer loan terms are used, keeping monthly payments down. The longer terms essentially transfer residual risks to the buyer.
“If consumers were willing to drive less-expensive vehicles than they leased, they could put more down on the vehicle and they wouldn't have to extend the loan term, making it less likely that they would be upside down,” says David McKay, senior director, Power Information Network.
“Unfortunately, once customers experience driving more expensive vehicles, they find it difficult to walk away from them. Instead they look to longer-term financing to keep payments manageable.”
Krouse says his dealership tries to show customers alternatives that avoid negative-equity situations.
Those options include buying a vehicle that has a substantial cash rebate rather than low-term financing.
For lenders, longer-term loans are less risky but they do carry risks.
In the case of a default one year into the loan, a lender's loss on a 3-year contract will be significantly less than a 5- or 6-year contract.
“Longer terms require lenders to have a better understanding of the market value of vehicles throughout the payment cycle, more conservative loan-to-value ratios and credit scoring,” says McKay.