Tony Hughes and Michael Vogan of Moody’s Analytics proposed what some finance company executives might consider an outside-the-box idea to help their customers who are stretching contract terms as long as possible in order to keep monthly payments affordable and then running into costly vehicle repairs.
Hughes and Vogan discussed their plan within a white paper shared recently with SubPrime Auto Finance News titled “Alternatives to Long-Term Car Loans?” The experts described how vehicle equity lines of credit could provide relief for consumers they categorized as “cash-strapped subprime borrowers.”
Before going into an example of how the strategy might be beneficial to both consumers and finance companies, the pair said, “These folks may not be able to afford the monthly payments on a traditional five-year loan but could cover a seven- or eight-year commitment. We briefly propose a solution that will allow budget-constrained borrowers to buy a vehicle, build equity therein, improve their credit standing, and still cover potential emergencies.”
Here’s how Hughes and Vogan explained the concept: “If I buy a new Toyota Camry with a minimal down payment, I will hold about a $12,000 asset after my five-year loan has expired. With an eight-year loan, by contrast, I will have about $1,000 in equity at the same point in the life of the vehicle.
“In terms of monthly principal payments, the five-year loan is about $150 extra per month at the outset of the period, assuming a 12 percent annual percentage rate on each loan. Interest payments are lower for the shorter term loan,” they continued.
“In comparing these loan structures, bear in mind that in one case, the borrower is being forced to save in the form of illiquid vehicle equity,” they continued. “In the other, the borrower pockets cash that can either be saved for a rainy day or spent on other forms of consumption.”
Hughes and Vogan called their recommendation “a middle ground” between the long-term loan and the traditional five-year financial structure. They suggested that a line of credit proportional to the amount of equity held in the vehicle is offered to the borrower at the outset of the loan. The line is initially zero, assuming that the vehicle is financed at full economic cost.
As loan payments consistent with a five-year term are made, and as equity in the car slowly builds, Hughes and Vogan pointed out the size of the available credit line also increases.
If the proposed structure uses a 50 percent multiplier, after one year a $500 secured credit line will be available to the borrower, according to the calculation by Hughes and Vogan. After two years, $1,500 will be available to the client to cover potential emergencies or spending requirements.
At the end of five years, the borrower will have clear title to a $12,000 car and a $6,000 credit line.
“There is no doubt that longer-term loans have expanded access to vehicle credit for poorer buyers,” Hughes and Vogan said. “The risks with such loans, however, are manifest.
“The industry should be looking at other, potentially safer ways to make vehicle finance accessible by subprime borrowers,” they continued. “The combination of a tougher five-year repayment schedule and access to a secured credit line may be a useful addition to the financial arsenal that might increase the welfare of borrowers and lenders alike.”