- Analysts warn that car buyers now face the risk of going underwater with car loans.
- Financing costs increase as the value of the vehicle decreases.
- “We’re only seeing the tip of the negative equity iceberg,” Edmunds analyst Ivan Drury said.
If you’ve recently taken out a loan to buy a car, especially a Tesla, chances are you’ll soon be paying more than it’s worth.
About 16% of consumers financing a new car and 5.4% of consumers financing a used car committed to monthly payments of at least $1,000 in the last three months of 2022, according to Edmunds, which tracks auto inventory and data. According to him, both figures are at a record level.
Higher payments come with lower vehicle values, which means consumers are left paying off the original balance of their loan — now with higher interest rates — even if their car is no longer worth it. According to the Bureau of Labor Statistics, used car prices in December fell 2.5% from November, while new car prices fell 0.1%.
This is classic “negative equity” where the value of the asset used to secure the loan is less than the outstanding balance on the loan. Also known as “underwater” or “upside down,” the scenario is bad for borrowers: If they can’t make the payments, then they can’t sell the asset and raise enough money to get out of debt. Lenders will likely repossess the car, leaving the driver with monthly loan payments and no car to drive.
“We’re only seeing the tip of the negative equity iceberg,” as auto prices, particularly used car prices, are expected to continue to decline, said Ivan Drury, director of insights at Edmunds.
Tesla buyers beware
To boost sales, Tesla made a surprise announcement last week that it would cut US prices of some versions of its best-selling Model Y SUV by almost 20% and the base price of its cheapest model, the Model 3. about 6%. The price cuts will make more of its cars available for the electric vehicle tax credit under the Inflation Reduction Act.
The move was immediate Backlash on Twitter of people who bought expensive cars in the last year. Not only did the price cuts lower the value of all new and used Teslas, but they also forced people to pay higher prices for loans.
“If you just bought one, you’re probably going to be upset and overwhelmed,” Drury said. “The ceiling is the price of a new car, and that ceiling has just collapsed.”
In the past two years, cars have been prohibitively expensive as supply chain snarls have prevented new cars from reaching the market. These high car values combined with low interest rates allowed people to use positive equity in loans and leases and buy even more expensive cars. Positive equity means that if you sell your car, you’ll have enough money to pay off your debt, and then some.
Martin Ellingsworth, executive director of P&C Insurance Intelligence at JD Power, said: “Over a period of time, some people have bought a car that has increased in value, used it, then sold it for more than its original cost, made a profit and driven away for free.”
“However, as we’ve moved into an environment of declining used car values and rising interest rates over the past several months, consumers have become less insulated from these risky lending decisions,” Drury said.
- Let’s say you financed $30,000 in 2021 for 60 months at 4%. You’ll have about $24,000 to pay by the end of the first year. So even if the value of your car drops to $27,000, you may still have positive equity.
- That contrasts with last month’s $30,000 financing at 7% over 60 months, where the car’s value could drop by several thousand dollars. After two months, you’ll still owe just over $29,000, which has already put you under water.
Of course, if interest rates continue to rise to slow the economy and cool inflation, as economists predict, the value of cars will fall further and more loans will be flooded, said Patrick Roosenberg, director of auto financing at JD Power.
“When sales slow, dealers and manufacturers will offer discounts to move them,” he said.
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In the fourth quarter, which ran from October to the end of December, 17% of new car sales had negative equity, compared with 15% in the fourth quarter of 2021 and 32% in the fourth quarter of 2020. Edmunds said. Meanwhile, the average amount owed on reverse loans rose to $5,341 from $4,141 in the fourth quarter of 2021 and $5,059 in the final quarter of 2020.
“Dealers who shop in November and December also take a hit,” Drury said. “They’re keeping money they don’t have anymore.”
What can you do?
As with homes, you may consider refinancing, but it may not make much sense if you see interest rates rise.
If you’ve already bought your car and have taken out a large loan, the best thing to do, Drury says, is hang on to your car for as long as you can. “Ride until the tires fall off,” he said.
Negative equity is “not a problem until your next transaction,” he said. “You’ll have positive equity in no time.” This is usually towards the end of your loan term when you have paid enough interest and principal to cover the initial wear and tear on your car.
If you haven’t bought a car yet and don’t need one right away, wait. Most analysts expect auto prices to continue to fall as the Federal Reserve raises the short-term fed funds rate to make borrowing more expensive to slow spending and inflation.
The Fed does not control consumer rates, but the effects of interest rate increases ripple through the economy and consumer rates usually follow. However, rate hikes will stall and remain higher this year.
This year, “it’s going to be back to normal,” Drury said. “People won’t pay more than MSRP (manufacturer’s suggested retail price). “Manufacturers will offer cashback and leasing agreements.”
How to find the best interest rates for car loans if you need to buy a car
Sometimes life changes require you to buy a car right away, or maybe you really, really want to buy a car now. If you can’t wait, here are some things to consider to get the best rate:
- Look for the best financing deal your credit score can give you. Credit scores affect the rates lenders can offer you.
- Consider adding a cosigner with a better credit score than you.
- Put more money into purchases to offset the increased costs. The average down payment for new and used cars hit record highs in the fourth quarter, rising to $6,780 and $3,921, respectively, Edmunds said.
- Take the shortest repayment term you can afford. Your monthly payment may be smaller for a longer period of time, but you may end up paying more overall.
Medora Lee is the money, markets and personal finance reporter for USA TODAY. You can reach him at email@example.com and subscribe to our free Daily Money newsletter for personal finance tips and business news every Monday through Friday morning.