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5 Reasons Not to Stretch Term

August 2007, F&I and Showroom - Feature

by Walter Cunningham - Also by this author

The auto finance industry continues to slide down the slippery slope of booking more and more loans with longer-term maturities. What’s worse is it’s happening across the entire credit spectrum. The 72-month term is quickly replacing the 60-month term for both new and used vehicles. The question is how this current situation will impact the automotive retail industry.

According to the 2007 Automobile Finance Study from the Consumer Bankers Association (CBA), 58 percent of new-vehicle loans had terms greater than 60 months. That has grown from 55 percent last year and 45 percent the year before. Used vehicle loans are no exception, as the study showed 48 percent of these loan terms were greater than 60 months, up from 40 percent reported in the 2006 study.

The impacts of this growing trend are many. On the lender side, the repercussions include slower repayment; greater severity of loss on repossessions; longer negative equity with a greater chance of the customer walking away from the loan; slower future vehicle sales for the automotive industry as a whole; reduced future down payments; and lower overall credit standards. So let’s take a look at each issue.

1. Slower repayment of the loan

The 2007 CBA Automobile Finance Study also revealed that, on average, the size of new- and used-vehicle loans remained relatively flat compared to the 2006 study results, with used-vehicle loans increasing slightly and new-vehicle loans showing a slight decrease. This puts the spotlight on terms, which saw significant changes between this year and last. The problem here is that lenders must wait longer to be repaid the principle loan balance advanced at the time of origination.

2. Increase in severity of expected loss

The next area of caution for lenders, and probably the biggest risk a lender incurs, is the increase in severity of expected loss at time of repossession. The probability of default due to longer terms naturally goes up, as does the expected loss at the time of default. For example, let’s take a $25,000 loan with a 10-percent interest rate and 72-month term. A repossession of that vehicle and a charge-off after 24 monthly payments will generate approximately $1,750 in additional losses when compared to a 60-month loan. This may not sound like much, but it quickly adds up when multiplied by a lender’s repossessions.

3. Longer negative equity

Similar to the increase in loss severity are the inherent risks associated with an increase in duration and exposure a lender must endure while his or her collateral possesses negative equity. As the vehicle depreciates during the life of the loan, the principle pay-down takes much longer to catch up to the actual wholesale value of the vehicle. The result is a longer and more severe period of negative equity that increases the loss in the event of a repossession or charge-off. The danger for lenders (in any negative equity situation) is that negotiating power in a default scenario is greatly reduced, increasing the chance that a customer may just walk away from the loan.

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