It's understandable that when they hear the words subprime and deep subprime loans, investors get nervous. After all, those words were tossed around quite often during the recent recession, where wealth in the stock market was shredded faster than incriminating documents during Enron's investigation.
More recently, Investors in big-name automotive manufacturers such as Ford Motor Company (NYSE: F) and General Motors (NYSE: GM) have become worried, in particular, about the increasing length of vehicle loans because it could push consumers' next purchase out even further. Nobody likes a longer purchase cycle in a cyclical industry. Let's dig in and figure out how many of these loans are to subprime consumers and what it means for the automotive industry and investors.
What's true and what isn't?
It's true that consumers are loading up on vehicles with higher price tags and are stretching loan lengths to achieve lower monthly payments. According to Experian Automotive, the average loan term for new and used vehicles increased to a record all-time high of 67 and 62 months, respectively.
Furthermore, auto loans with a term of 73 to 84 months, or roughly between six and seven years, increased to a record 29.5% of all new vehicles financed in the first quarter of 2015. That's up significantly from the 9% level five years ago and up modestly from last year's 25% mark.
In addition to longer loan lengths becoming the norm, more and more consumers are banking on financing to purchase their next set of wheels. In the fourth quarter of 2014, new and used vehicles financed rose to a respective 84% and 55% of total units sold -- which again means consumers will remain underwater on their loan principal longer.
So, as more and more consumers are buying more expensive and often larger vehicles, isn't that good for Detroit automakers that sell more crossovers, SUVs, and trucks?
Sure, in the short term, easily available and cheap financing has helped fuel new-vehicle, SUV, and truck sales to near pre-recession levels, which makes automakers more profitable. However, as longer loan lengths tack on extra interest bills for consumers, the concern is that the latter will be forced to hold on to vehicles longer as their equity breakeven point will be pushed further into the future. Thus, if the sales cycle for new vehicles slows, the auto industry could be in store for a slower and longer product sales cycle.
That's not something any long-term investor in the automotive industry wants to hear. But don't panic yet, because there are reasons to remain positive even as longer loans become the norm.
Michael Collins, senior vice president of F&I solutions at Dealertrack, offered an interesting insight to Automotive News' Hannah Lutz:
The increased term beyond 72 months is very, very heavily weighted to prime and superprime. The assumption is there is a gap between the unamortized balance of the transaction when the customer wants to bring the car back and get a new one and what that car was actually worth. With a credit score over 660, I think there's an assumption implicit in the lender's approval that that customer can afford it.
You know what they say about assuming things. However, the reasonable observer would probably have thought that the longer loan lengths would be tilted more toward subprime borrowers. According to Collins, that's incorrect, and because the longer loan lengths are from consumers that can easily afford to switch vehicles, regardless of equity being built up more slowly over a longer loan length, it shouldn't extend the product sales cycle.
Digging into more figures from Experian Automotive, subprime loans made up 16.2% of the market and subprime combined with deep subprime loans made up the lowest percentage share of the market since 2012. Moreover, 30- and 60-day delinquencies, respectively, declined 4.1% and 3.2% in the first quarter of 2015 compared to the previous year.
Ultimately, it's understandable that long-term investors would be worried at first glance of the longer loan lengths. With subprime and deep subprime loans representing a smaller share of the market, as well as healthier consumers representing a heavier share of loans exceeding 72 months, the issue seems to have been overexaggerated or at least misunderstood.
These are still important figures for automotive investors to keep an eye on, but right now longer loan length isn't a negative. Instead, it appears to be a positive for major automakers like Ford and General Motors.
Daniel Miller owns shares of Ford and General Motors. The Motley Fool recommends Ford and General Motors. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.