Rising Auto Loan Rates Shouldn't Be A Worry

By Lacey Plache August 10, 2011

Car shopping dealer lot -- iStock.jpg

There are plenty of things to worry about with the latest debt “crisis,” but rising auto-loan rates on new vehicles won’t be one of them. Interest rates on auto loans are not in danger of rising substantially in the near term, despite the downgrade of U.S. government debt by Standard & Poor’s on August 5.  There will be limited pressure on yields to rise on loans that are connected to government debt (in the form of U.S. Treasuries) – including auto loans. And, the Federal Reserve said this week it intends to continue to support lower interest rates across the spectrum.

However, the downgrade does highlight two bigger issues facing car sales - the weakness of underlying economic conditions and the associated impact on consumer confidence.  Although car sales currently are expected to grow based on the industry’s recovery from the Japanese earthquake, falling confidence in economic conditions, as shown by the recent stock market declines, has the potential to derail growth in autos. While the risk to new-vehicle sales from falling confidence is undoubtedly higher as a result of the downgrade, favorable buying conditions – increased vehicle availability, increased incentives, and continued low interest rates – should offset much of the debt downgrade’s effect on broad consumer confidence.

The Impact of the Debt Downgrade on Rates
Standard & Poor’s downgraded U.S. Treasuries with maturities of more than one year to AA+ from AAA, the highest rating, after the close of the markets on Friday, Aug. 5. Monday, Aug. 8 was the first day the markets had to react to the downgrade, and markets around the world lost value. The Dow fell more than 600 points, its worst one-day drop since December 2008. Ironically, yields on Treasuries actually dropped, due to an increase in demand for these assets. So despite the market-roiling downgrade on U.S. debt, investment in U.S. debt increased for two key reasons. First, regardless of the downgrade, U.S. government debt remains one of the safest havens in the world. The uncertainty created from markets losing Government Bonds with S&P AAA Ratings.jpgvalue, as happened Monday, causes risk-averse investors to retreat to safer investments. Hence, demand rose on such assets as gold, the Japanese yen, and, yes, U.S. Treasuries.

The second reason for the increase in demand is that Treasuries are extensively used by many firms and other borrowers worldwide as collateral for loans. There are very few other assets with AAA ratings combined with the liquidity of Treasuries. As a result of increased demand, prices rose on Treasuries and yields fell. Accordingly, the rates of assets connected to Treasuries, including auto loans, are not likely to rise. Historically, average new auto loan finance rates have tended to move with Treasuries.

Help from the Fed
Another factor that can potentially help keep auto loan interest rates lower is the Federal Reserve’s current policy regime.  The Fed said Tuesday that it will keep the target range for the federal funds rate at 0 to 0.4 percent through at least mid-2013. This policy will support lower rates across the spectrum – including for auto financing – for the next few years.

The Fed also indicated that it will continue to hold Treasury securities and to reinvest principal payments from its holdings. By not selling its Treasury holdings, the Fed will not increase the supply of Treasuries, which would drive prices down and yields up. The Fed’s policy of reinvestment contributes to keeping interest rates lower by helping to maintain demand for Treasuries (which will result in higher prices and lower yields).

Rate Protection from Automaker Incentives

Even if auto loan rates did rise as a result of the debt crisis, consumers could face little or no rate increases due to the ability of automakers to offer finance incentives on auto purchases. Even in recent years, when interest rates have hovered at multi-decade lows, automakers have continued to subsidize rates for consumers, with the result that many consumers have virtually come to expect to purchase a new vehicle with a zero-interest loan.

Any trend towards higher auto loan rates from banks or other lenders might tangentially improve revenue for automakers, but also puts sales at risk. In addition to gaining sales, automakers benefit from offering finance incentives from their captive lending units because those programs can be used to target more credit-worthy customers, who tend to purchase more expensive vehicles and are more likely to be repeat customers. Automakers have an additional incentive to subsidize interest rates because, unlike cash-based incentives, finance-based incentives do not affect the vehicle’s residual value.

Average Auto Loan APRs vs. 10-Year Treasury Yields.jpgLending Competition Will Prevail
In addition to the downgrade, another potential threat to auto loan interest rates comes from lenders. While rates on U.S. Treasuries are unlikely to force auto loan rates to rise in the near term, banks may have an incentive to hike loan rates in order to increase revenue. Banks are currently looking for additional sources of revenue because the cost of holding deposits is rising.

Lender Share of New Auto Loans.jpgA rate-raising strategy is unlikely to be profitable for auto loans, however. Banks typically face strong competition from the automakers’ captive finance companies, which accounted for 39 percent of new car financing in THE 2011 first quarter versus the banks’ 45 percent. Captives have an inherent advantage over banks in that they work through car dealers to offer financing to buyers and thus can provide a competing offer for many potential customers. They also face a different cost and revenue structure, in part because they typically specialize in auto loans and also because they tend to receive financial support from the automakers themselves. As such, these lenders likely won’t face the same pressures as banks to raise auto rates. Any attempt by the banks to unfavorably raise rates would likely be met by competitive rates from their captive finance company competitors.

Real Issue Is Falling Confidence

In the near term, new-vehicle sales should not be constrained by rising interest rates due to the downgrade of U.S. debt. It is unlikely that interest rates on auto loans will rise significantly as a result of the debt downgrade. Rather, the challenge to car sales comes from the decrease in consumer confidence brought on by the downgrade. Fortunately, the downgrade has not negatively affected buying conditions. Buyers will continue to find growing availability of vehicles as production returns to normal for the Japanese automakers. Increased supply and competition for market share will mean automakers offer more incentives. And, interest rates should remain steady. As a result, the sales momentum will grow in the months ahead.

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