McLEAN, Va. — Larry Dixon, senior manager of market
intelligence at NADA Used Car Guide, recently took a deep look at how much the
access to vehicle financing has played a significant part in "helping to grease
the skids for the industry's performance."

Dixon began by pointing out historically low auto finance
rates have kept monthly payments essentially flat despite both new- and used-vehicle
prices rising substantially during the past five years. Citing Experian
Automotive data, the average amount financed for new and used vehicles grew by
3 percent ($25,789 to $26,526) and 5 percent ($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, Dixon noted
Experian data shows the average monthly payment on a used-vehicle loan
increased by just $4, while the monthly payment on new-model contracts actually
dropped by $7.

Furthermore, over the past three-plus years, monthly
payments for both have varied by just $6 and $2, respectively, according to
Experian's information.

"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," Dixon said.

Dixon again referenced Experian data that indicated the
average length of new-vehicle loan terms grew from 63 months at the end of 2010
to 65 months through the second quarter of this year while used-vehicle loan
terms grew from 58 to 61 months over the same period.

The NADA UCG expert also pointed out that currently more
than 61 percent of all new-vehicle loans are greater than five years in length,
up from 55 percent 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
percent).

"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," Dixon said.

To reinforce his assertion, Dixon again referenced Experian
data — this time specifically mentioning the subprime sector. Experian's data showed
that the share of all used-vehicle loans grew from a low of 34.5 percent in the
second quarter of 2010 to 40.3 percent in Q2 of this year and is now within
striking distance of the pre-recession figure of 42.4 percent established in
the second quarter of 2007

Dixon went on to note that consumer and lender appetite for
autos have pushed total outstanding auto debt up by some 13 percent to nearly
$800 billion since the beginning of 2011, a figure just shy of the $807 billion
average recorded during 2006 and 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,"
Dixon said.

"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)," he continued.

"This is a good thing of course as positive equity helps to
support the purchase of a new or pre-owned used vehicle," Dixon went on to say.

Dixon cautioned both dealers and lenders. He asserted that while
contract rates are exceptionally low today, this situation 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," Dixon said.

To illustrate his point, Dixon offered this example. If
used-vehicle loan rates were to increase from 8.56 percent — Experian's most
recently stated average rate — to 11.56 percent, 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," Dixon said.

"From an equity perspective, of greater negative consequence
is the trend towards longer loan terms combined with higher interest rates," he
continued.

Dixon went back to his hypothetical loan amount of $17,000
over a 60-month term at 8.56 percent originated in September. Relative to NADA
UCG's used-vehicle price forecast for the next couple of years, Dixon indicated
a consumer would begin to consistently accrue positive equity in their vehicle 17
months into the loan term (or in February of 2015).

After a period of three years, Dixon estimated the difference
between market value and loan balance would be $1,800. 

"Bumping the rate up to 11.56 percent 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," Dixon said.

Dixon calculated that when the rate is pushed to 11.56 percent
and the term is extended by six months to a total of 66, equity accrual begins
after a period of 29 months (February 2016) — 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 and more, it clearly conveys the joint impact of longer loan terms
and higher interest rates," Dixon said.

"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," he continued. "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. 

Dixon insisted that "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.

"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," Dixon said.

"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," he concluded.

Dixon created a series of charts to illustrate more trends
as a part of his original online post about this topic, which can be found
here.

Continue the conversation with SubPrime Auto Finance News on LinkedIn and Twitter.


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