Much has been made of the role pent-up demand has played in the recovery of new and used auto sales – and to a lesser extent, the strength in used vehicle prices – over the past year or so. Slightly less trumpeted has been the progressively important part credit has played in helping to grease the skids for the industry’s performance.
 
It’s common knowledge that both new and used vehicle prices have risen substantially over the past five years, but historically low auto finance rates have kept monthly payments essentially flat. For example, per Experian Automotive data (which I’ll cite frequently throughout this post), the average amount financed for new and used vehicles grew by 3% ($25,789 to $26,526) and 5% ($16,992 to $17,913), respectively, from the fourth quarter of 2010 through the second quarter of this year. 
But despite the increases in finance amounts, the average monthly payment on a used auto loan increased by just $4, while the monthly payment on new loans actually dropped by $7. Furthermore, over the past three-plus years, monthly payments for both have varied by just $6 and $2, respectively. 
 
Falling interest rates aren’t solely responsible for the payment stability we’ve witnessed over the past few years, but rather it’s been a combination of lower rates and stretched loan terms that have held monthly payments in check. The average length of new auto loan terms grew from 63 months at the end of 2010, to 65 months through the second quarter of 2013, while used loan terms grew from 58 to 61 months over the same period.
 
Currently more than 61% of all new vehicle loans are greater than five years in length, up from 55% less than two years ago, and half of all used vehicle loans are now above the same five-year threshold (up from late-2011’s figure of 45%).
 
The extension of loan terms is just one indication of how loan standards have loosened after tightening considerably during the recession, as low cost of funds, high used vehicle prices, deleveraged consumers, and intense competition have lenders increasingly willing to finance auto purchases across the credit spectrum. For example, the subprime share of all used auto loans grew from a low of 34.5% in the second quarter of 2010, to 40.3% in Q2 of this year and is now within striking distance of Q2 ‘07’s pre-recession figure of 42.4%.   
 
Consumer and lender appetite for autos have pushed total outstanding auto debt up by some 13% to nearly $800 billion since the beginning of 2011, a figure just shy of the $807 billion average recorded over 2006 – 2007.
 
It’s this alignment of high demand and cheap money that has been largely responsible the rapid ascension of auto sales this year and one that is helping to sustain used vehicle prices at a historically high level. 
 
The prevailing low interest rate environment also means that consumers are paying less on interest each month and more towards the principle balance of their auto loan, which ultimately cuts down on the time it takes to reach a positive equity position on their vehicle (i.e. the car or truck is worth more than what is owed to the lender). This is a good thing of course, as positive equity helps to support the purchase of a new or pre-owned used vehicle.
 
But while auto rates are exceptionally low today, this won’t always be the case. Fortunately rates would have to jump rather dramatically to have a significant impact on monthly payments, or the expense the majority of consumers are most concerned with. For example, if used auto loan rates were to increase from 8.56% – Experian’s most recently stated average rate – to 11.56%, the monthly payment on a $17,000 loan over a 60 month term would go from $349.27 to $374.39 – an increase of $25.11 per month. While a $25 per month payment increase would likely be readily absorbed by a large percentage of consumers, it would have a negative impact on a below-prime consumer’s debt-to-income ratio and thus their ability to secure financing.
 
From an equity perspective, of greater negative consequence is the trend towards longer loan terms combined with higher interest rates. Here’s a simple exercise to illustrate this point. 
 
Returning to our hypothetical loan amount of $17,000 over a 60 month term at 8.56% originated in September 2013, relative to NADA’s used vehicle price forecast for the next couple of years, a consumer would begin to consistently accrue positive equity in their vehicle seventeen months into the loan term (or in Feb. ’15). After a period of three years, the estimated difference between market value and loan balance would be $1,800.  Bumping the rate up to 11.56% doesn’t change the point in which positive equity begins to accrue, but it does reduce the amount of equity to $1,492 after a period of 36 months because more money is allocated to interest over the period rather than principle. 
 
When the rate is pushed to 11.56% and the term is extended by six months to a total of 66, equity accrual begins after a period of 29 months (Feb. ’16) – a full year longer than the prior two scenarios – and after a period of 36 months the difference between market value and loan balance is just $417.
 
While this was an elementary exercise with details omitted such as purchase prices, down payment, equity position relative to retail or wholesale value, etc., it clearly conveys the joint impact of longer loan terms and higher interest rates. 
 
Thankfully neither terms nor rates will rise dramatically overnight, but current trends and history strongly suggest that they will progressively grow in the foreseeable future. This of course presents a series of unappealing implications for the industry at large, such as the longer it takes for a consumer to reach a positive equity position in their current vehicle, the longer they will remain out of the market for a new or pre-owned used one.  
 
Some tough decisions will need to be made at some point to mitigate the threats posed by higher rates and longer terms – especially given that used vehicle depreciation is expected to increase materially from today’s exceptionally slow pace within the next two years – and clearly lenders face a difficult balancing act comprised of growing their business through today’s favorable conditions while also keeping an eye on future downside risk. 
 
Simply put, even though times may be good today, hard lessons learned in the past have made one thing perfectly clear – they won’t always be.