Auto loans could be the next financing bubble

Colorado Springs Business Journal, Apr 18, 2008 by Rebecca Tonn

Automobile financing could be the next subprime mortgage crisis.

Underwriters used to finance cars and trucks for three years, but since the 1970s the length of the loans has crept up to four, five or six years. Now seven-year auto loans are commonplace, much like 30-year home mortgages have slowly but surely replaced traditional 15-year mortgages during the last few decades.

Advertisers would have consumers believe that a seven-year auto loan is a modern necessity. But Americans might simply be buying more car than they can afford -- akin to the don't ask/don't tell heyday of no-proof-of-income, no down payment subprime residential mortgages.

In retrospect, pundits said consumers were buying homes beyond their means. How long until the drive-a-car-that-equals-your-salary bubble bursts?

"You can't fault the dealer for it -- they're trying to promote business," said Fred Crowley, senior economist at the University of Colorado at Colorado Springs. "But seven-year auto loans are the subprime housing market equivalent. The underwriter should know this is a stupid business."

A seven-year car loan makes sense, Crowley said, for the rare person who's going to "drive the car into the ground." But consumers who frequently trade in their cars should stick to short-term loans.

The credit crunch has hit the auto business, just like it hit the housing business, said Phil Bonfanti, senior operations manager at Phil Long Ford. He remembers when 24- to 36-month loans were the norm.

But economic conditions dictate the terms of financing.

"It's just like homes. We'd like to have 15-year mortgages, but most people have 30," Bonfanti said. "Manufacturers, banks, retailers, consumers -- we'd all love to see people in short-term loans. It's cut and dry: seven-year loans lower payments. The downside -- I don't care what make the car is -- you're liable to be upside down from the get-go."

The upside to long-term auto loans, he said, is that because of technology, cars hold their value longer and are of better quality than they were 20 to 25 years ago -- or even 10 years ago.

Bonfanti said that seven-year loans are not contingent on the price of the vehicle. People who make $25,000 per year take out seven-year loans on $20,000 cars, while those making $200,000 per year purchase $100,000 vehicles.

For perspective, the monthly payment on a $30,000 car financed with a seven-year loan at an 8 percent annual percentage rate would be $557.

Ed Sauer, president and CEO of Bank at Broadmoor, said he's not in favor of seven-year car loans or auto advertisements that promote only a monthly payment -- not the actual price of the car.

"I'm a dinosaur," he said. "I remember when auto loans increased to four years, and I thought, 'How is that going to work?' To owe more on anything -- house, car, boat or furniture -- than it's worth is not a good thing. If seven years makes that much of a difference than a five- or six-year loan, then maybe the decision to buy that expensive of a car needs to be reconsidered."

Consumers usually don't keep an automobile for seven years -- five years is average, Sauer said. And, historically, people do not pay off auto loans early.

"The interest you pay on a car loan is not tax deductible, so it's in your best interests to pay if off early," Sauer said.

Long-term car loans have their place in the market for certain people, said Bruce Gillooly, assistant vice president of corporate communications for Security Service Federal Credit Union, but only if the financer practices due diligence and the consumer understands the benefits and liabilities of such a loan.

"We tailor our programs to individuals. Part of good service is making sure we and the (credit union) member are comfortable with the agreement," Gillooly said. "Someone who is perfectly healthy and takes blood pressure medicine may not be as well off tomorrow as they are today."

The same principle applies to taking out a seven-year car loan -- if it's not the right loan, the individual might not be as financially healthy afterward. And there is the potential, he said, for cars to be repossessed if consumers are financially overextended.

"In the marketplace today, consumers live beyond their means simply because they are permitted to by certain financial institutions," Gillooly said.

Before agreeing to a long-term loan, consumers should be aware that depreciation of an automobile is not an exact science, Bonfanti said. No one can guarantee what a car will be worth in seven years.

A rare vehicle in high demand can increase in value, he said, and others can "drop like a brick." Value is determined by the market, condition of the vehicle, fuel prices and current economic conditions.

Financial advisers and economists encourage consumers to determine the potential benefits and dangers, before committing to a long-term loan.

"Others will tell you that long-term car loans put people into affordable cars," Crowley said, "but we already tried that with affordable housing."