According to Desrosiers Automotive Consulting data, Canadian new auto sales sped past 2M units in 2017 and fell just short of that level in 2018. That volume, alongside a solid used car market, has been a major source of horsepower for the run-up in Canadian consumer debt in recent years. But, with the Bank of Canada raising rates, the dynamics of the auto market are shifting.
Coming to terms with leasing
The rising cost of funding loans is making it more expensive to offer 84 and 96 month terms. The result has been a surge in leasing—particularly in the luxury market. As new car sales moderate, used car sales are expected to remain solid and will provide a low-cost alternative as loan terms tighten.
Extended loan terms are critical to a car manufacturers’ arsenal. Cox Automotive Canada data shows more than 70 per cent of new car loans had terms of 6 years+ for the past two years. The result was a significant shift away from leasing. By extending terms, car dealers were able to get monthly payments down to levels comparable with 36 – 48 month leases. Consumers shopping for low monthly payments had more choice.
As terms have adjusted, leasing has surged. Leasing fell to less than 20 per cent of auto lending after the financial crisis, as manufacturers retrenched and looked to reduce the risk of residuals in an overstocked used car market. In Q2 & Q3 of 2018, leasing represented almost two-thirds of new auto captive financing. It’s not quite a potato-potatoh situation. Leasing has implications for both the lender and consumers.
As the market shifts and consumers look for affordability, the underlying credit fundamentals are changing for consumers and lenders. With the most recent announcement, the Bank of Canada has lifted rates by 125 bps and, while there is some short term uncertainty, there is likely more to come. The earlier decisions are already weighing on consumers’ balance sheets. With almost 45 per cent of non-mortgage debt sitting in lines of credit, each rate hike hits directly at the cost of these typically variable rate products.
The impact is already evident. As a previous blog discussed, consumers are less likely to pay off their credit card in full every month. Cash flows are tightening. As rates edge higher, the impact will only grow. Those with home equity lines will be particularly impacted. They tend to be older borrowers and may be more likely to consider the luxury vehicles that are reporting the most significant rise in leasing.
There are already signs of stress in auto portfolios. After a strong winning streak, car loan delinquencies were up in both Q2 & Q3 of 2018. For loans, this, at least partly, reflects the lag effect of delinquencies. As most consumers can make the first few payments, it often takes time before delinquencies become evident. When the growth in new balances slows, the lag effect keeps the numerator rising faster than the denominator in the delinquency rate calculation. That is just part of the story for auto loans.
Beyond the mathematical impact, there are broader signs of weakening. Auto loan delinquency was up in all provinces in Q3 – not as common for other products. Lease delinquency was effectively flat, which is worrying given the strong growth, and British Columbia and Quebec were the only provinces with lower lease delinquency for the quarter. The 65-plus age group has felt the most significant impact of higher interest rates with overall delinquencies for that cohort now up for two straight quarters. This group reported higher delinquency for both auto loans and leases in Q3. This aligns to our previous blog, given their higher use of home equity lines of credit.
Lenders need to watch the swap
As auto portfolios begin to strain, loans may be more impacted by a swap out of good accounts. Leasing is most popular in the luxury car segment, which entails stronger credit profiles. This will result in a shift in credit quality from auto loans, as those that would have used long terms may choose leases now. With the big banks limited in their ability to offer leasing directly, that may mean a downshift in the credit quality of their auto loan portfolio. This bias drives lower delinquency rates for leasing, and will have a longer term impact on those portfolios with a heavy loan weighting.
Stay in your lane and check your blind spots
The underlying lane changes in the auto market are not the end of the good times, but there are implications for both lenders and consumers to consider.
For lenders, it’s time to prop up the back end. There has been little shift down market, with credit acquisition strategies still proving effective. Managing delinquency and maximizing recoveries will be the important levers for any portfolio. The type of consumer hitting collections is likely to change with a rising share of older borrowers in the queues. That will entail some tweaks to collection strategies given their profile. Now more than ever, know thy customer!
On the consumer front, it is time to question the car-buying decision. Leasing is not the right answer for everyone and shouldn’t be used simply to minimize monthly payments. With rising debt levels, it will often create a financial situation, as the vehicle never gets paid off. Used cars are an affordable option and the traditional fixed rate loan will provide greater payment certainty.
Keep in mind, the long-term interest rate offers come at a cost. Dealers have less flexibility to negotiate, which often increases the final price of the vehicle. Understand your options and the long-term plan for your vehicle. If you don’t plan on moving into a new car every few years, leasing may not be the right choice. The lowest monthly payment isn’t always the best option.
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