Something has to Give: How Bloated Incentives are Harming the Industry | Auto Finance News


New vehicles are getting more expensive, but so far those price increases have done little to dissuade consumers from pulling the trigger on new-car purchases or leases because manufacturer incentives have been so generous. However, incentives and production could be taking a downturn as auto sales slow.

Average incentive spending through February rose year over year for the 50th straight month, but there were signs of some cracks in the armor. Mainstream, non-luxury, spend fell $54 per unit during the month compared with the same period the year prior.

“That leaves premium spending as the culprit,” Tyson Jominy, director and head of PIN Consulting at J.D. Power, told Auto Finance News. Spending on luxury brands in February increased 16% year over year — or $898 per unit to $6,561 — to its highest-ever February level. The increase also marked the fourth straight month with an incentive boost greater than 15% versus the prior year, he said.

Vehicle sales are expected to slip to 16.7 million units in 2018, from 17.1 million last year. One of the primary drivers of that decline is an expectation that consumers will opt for less expensive used vehicles rather than their newer counterparts.

“Consumers may be moving into used-car financing because new-car financing is high, and new-car loan amounts have continued to grow,” said Melinda Zabritski, senior director of automotive financial solutions at Experian. “There’s more bang for your buck on the used-car side.”

New-vehicle loan amounts rose to a record high of $31,099 in the fourth quarter of 2017, up $509 year over year, according to Experian’s Automotive Finance Report. Meanwhile, even with a $300 increase in average amount financed, used vehicle prices hovered about $12,000 lower than new-vehicle prices.

It’s not just that the prices of used cars are lower than new — they always are — but financing is turning in favor of prime borrowers looking for used cars. The average interest rate for high-credit borrowers has fallen nearly 10% on used vehicles since the first quarter of 2015, according to WalletHub’s 1Q18 survey.

New-vehicle interest rates from captives averaged 1.87%, compared with 3.13% industry-wide. By comparison, used-car interest rates avareged 4.18%, WalletHub reported. This level of special rate financing can be damaging for the industry.

“There are many downstream effects of higher incentive spend, but the one we are primarily focusing on is its impact on residual values,” Jominy said. “Higher incentives lead to eroding actual, and perceived, value of vehicles, which means consumers will require longer to reach positive equity in their loans.”

“While rising transaction prices for the industry overall and reduced spending in some segments of the market is a positive indicator for the long-term health of the industry, sustaining lower levels of incentives will be challenging,” J.D. Power wrote in the report. “Considerable potential exists for spending to rise … in the months ahead.”

However, the incentive spending hasn’t been enough to stem growing interest payments as the Federal Reserve raises its rates. Captive new-car financing rose to an average rate of 1.87% in the first quarter, up from 1.77% the same period the year prior, according to WalletHub. Likewise, captive leasing rates grew to 5.13% in the quarter, compared with 4.38% in 2017.

“Given that we’re forecasting interest rates to rise even more than they are today, that’s going to make loans more expensive over their payment lifetime,” Michael Vogan, an automobile economist in the credit analytics department at Moody’s Analytics, told AFN. “As the price of cars also go up, if consumers want to keep their payment plan at the levels they are today, something has to give.”

That means either interest rates could rise, consumers could turn to cheaper but relatively new off-lease vehicles, or lenders could extend terms further out.

Average loan terms for new vehicles increased to 69 months in the fourth quarter of 2017, up from 68 months in the year-prior period, according to Experian. Meanwhile, average loan terms for used vehicles rose 0.26 months to 64 months.

“The question is, how far can [terms] go — and I think that’s an outstanding question,” Vogan said. “Banks could [increase] the net-equity risk — having the borrower be in negative equity for longer. I could see loan terms getting extended a little more, if that’s what’s required on the demand side, if that’s what consumers want.”

The Impact of Tariffs

Last month, President Donald Trump enacted a 25% tax on imported steel, which may further increase the production cost of domestic cars.

“Tariffs do have the potential of increasing the cost of producing cars in the U.S., so you could see a shift in production overseas,” Vogan said. “I don’t know what the causal chain to the finance industry would be, but it’s something the automotive industry as a whole has their eye on.”

One possible effect is an intensification of the pricing difficulties already outlined above. More expensive cars mean lenders and manufacturers have to come up with new ways to lower monthly payments for consumers.

OEMs could reduce production to mitigate pricing pressures, but those plans are already underway due to the excess off-lease volume in the market.

“You have to provide a lot of incentives because there’s so much competition from the off-lease volume, which is forecasted to peak in 2020,” Vogel said. “Going forward, you’re already coming down off that peak. From an off-lease volume perspective, I don’t think the production adjustments are going to help mitigate any price pressures we’ll see over the next three years.”

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Increased Competition From Credit Unions

Incentives could also be on the rise as captives feel the pressure from credit unions, Experian’s Zabritski said.

“As we see these rate increases, we’ll see more incentives coming out of the captives to remain competitive and drive sales,” she said. “Certainly, as you have rate increases, credit unions have some advantages: They have a different cost of funds, they operate in a different competitive environment, and they operate in a different regulatory environment.”

Credit union marketshare grew 200 basis points year-over-year to 21.1% of the market in the fourth quarter. Meanwhile captives were able to grow at a similar clip to 29.9% of the market in the fourth quarter, up from 28.4% the same period the year prior.

More prime consumers are expected to choose used vehicles over new in 2018, and credit unions are poised to offer the best rates to those consumers, Zabritski said.

“Credit unions tend to finance much more heavily in used vehicles, especially compared to captives that are mostly new,” she said. “The credit unions are picking up marketshare left and right, and really expanding in the marketplace. They aren’t that far behind the banks in the used-car industry.”

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Source : AutoFinanceNews