Being upside-down on a loan is a common situation for CU members.
It's an all too common situation. A couple named Lisa and Roger own a vehicle that increasingly presents expensive mechanical issues, feels dated in terms of technology, and is too small and unreliable for a growing family. They're eager to get into a newer car but the value of the current car is $10,000 and they owe $15,000. They are "upside down" on the loan and in a bind to purchase a new vehicle.
They are far from being alone in this situation. According to Edmunds.com, 32.5% of U.S. borrowers who trade in vehicles are in a negative equity situation by an average of $5,100 as of the last quarter of 2017. Moreover, these borrowers often end up in a negative equity cycle that is extremely difficult to break.
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Combine these challenges with the fact that vehicles are more expensive than ever and that interest rates are going up. In response, to help consumers get into a newer car with an affordable monthly payment, financial institutions are extending terms from what have typically been 48 to 60 months to 84 and 96 months in some cases. Longer terms do lower the payment but unfortunately extending terms can trigger and exacerbate the negative equity challenge. Borrowers will often go upside down on a loan and into negative equity at 48 to 72 months primarily due to depreciation. If Lisa and Roger roll over their negative equity into another loan with an extended term, it is likely they will find themselves on the negative equity treadmill just a few years down the line.
The Numbers
When considering Lisa and Roger's situation and their need for a newer, more reliable vehicle, it's important to look at Loan-to-Value. The lower the LTV, the better position Roger and Lisa are in to sell and buy a new vehicle.
For example, if Lisa and Roger are financing a new car for $50,000 plus $15,000 (rollover for their outstanding balance on their trade-in) for a total of $65,000, the LTV would be 130%.
Consumers are indeed reaching up to 125% to 150% of LTV, which creates a serious negative equity cycle. Negative equity has implications for both the borrower and financer that make it compelling to help members and customers with alternatives. If we want to focus on loan growth as financial institutions, we need financially healthy buyers.
Alternative Options
The following are three underutilized approaches to help get members off the negative equity cycle:
1. Stepping off the treadmill with a residual-based, walk-away balloon loan.
Lisa and Roger continue to need a reliable vehicle. If they are at 130% LTV, they could finance their purchase with a balloon loan that includes a walk-away option. For example, let's say they finance the $50,000 vehicle at 130% LTV, which is $65,000. The lender deducts the guaranteed residual value from the $65,000 to calculate the vehicle monthly payment, resulting in a lower, more affordable monthly payment. At the end of the term, the consumer elects to turn the vehicle in and walk away. Lisa and Roger are now out of the negative equity cycle while being able to drive a newer, more reliable, family-sized car.
2. Recapture programs.
Recapture programs help financial institutions by providing offers that attract members such as Lisa and Roger back to the credit union to refinance their vehicle and lower payments on a conventional loan, or to put them into a residual-based loan like a balloon or lease. Not everyone qualifies, but this approach can effectively help members lower monthly payments and break the cycle.
3. Workout loans.
If Lisa and Roger go into default, it's not good for anyone. As an alternative to turning in the keys and defaulting on the loan because their payment is too high, the consumer could refinance, if they qualify, into a residual-based loan like a balloon or a lease. The result is a more affordable payment and the consumer keeps the vehicle and gets on a path to breaking the default cycle.
With negative equity in the U.S. growing from 23% in 2012 to 32.5% by 2017, it's clear that helping members get off the treadmill is important. Credit unions have much to gain by working with borrowers to be healthy, long-term members who can afford to buy new vehicles as demand grows. These are a few of the ways to get consumers back on track for everyone's benefit.
Negative Equity Trends at a Glance
- To address demand for lower monthly payments on increasingly expensive vehicles, financing is being extended from 48 to 60 months to 84 and 96 months.
- Negative equity for trade-in vehicles in the U.S. has grown from 23% in 2012 to 32% by last quarter of 2017. One-third of these owners are under water (Edmunds 2018).
- The amount of negative equity has also increased, up from $4,500 in 2015 to $5,100 in 2017 (Edmunds 2018).
- Increased demands for new cars and vehicle loans will likely lead to strong sales growth in both new and used cars in 2018.
Tim Kelly Tim Kelly is President of Auto Financial Group. He can be reached at 713-817-5858 or [email protected].
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