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updated 2/26/2004 3:50:19 PM ET 2004-02-26T20:50:19

At the Vann York Pontiac and Buick dealership in High Point, North Carolina, it is quite common for customers to trade in a two- or three-year-old car even though they still owe $5,000 on their original loan.

Salesman Efim Grand says drivers are keeping their cars for ever-shorter periods - but taking out longer and longer loans, to try to keep their monthly payments flat.

"People want to trade in after two or three years, but they won't be even on their loan for four or four-and-a-half years," he says, adding that he has seen loans of up to seven years.

The willingness of drivers across the US to trade in before paying off loans has boosted the American car industry, where sales are close to record levels.

But the number of people with negative equity on cars — or "upside-down" loans — is a potential time bomb for the manufacturers.

Customers have been spending record amounts on new cars, with the average vehicle selling for $28,835 in December, up from $21,608 five years ago. But this has only been possible thanks to a combination of the Federal Reserve's "easy money" policy and ever-longer loans.

Now the Fed has indicated that rates have bottomed out, customers face two options for keeping their payments flat - extending the loan term even further, or buying a cheaper car.

Cheaper cars mean lower profits for the industry. Longer loan periods, meanwhile, raise the risk of default for lenders — mainly the finance arms of the big carmakers, such as General Motors Acceptance Corporation or Ford Credit — and can only help sales in the short term.

The trick cannot be repeated indefinitely: Eventually the sales hangover has to be confronted as consumers decide to pay down debt rather than upgrade their cars.

"The way to cure this problem of negative equity is to just drive your car," says Bob Kurilko, a vice-president at Edmunds.com, the Californian automotive research group. "Stay in it and pay off the loan."

Edmunds calculates that 28 per cent of drivers looking for a new car had an average of $3,800 of negative equity in January. If all of them took Mr. Kurilko's advice, it would take more than eight months to clear the debt - and cause a massive, if temporary, drop in sales.

"The initial upsurge in rates is not going to dent the auto industry. But later in the year and into 2005, it is going to be especially hazardous," says David Littmann, chief economist at Comerica Bank in Detroit. "It is going to lead to plummeting auto sales."

This year, he predicts, tax breaks and other political actions during the presidential election campaign will support auto sales by boosting disposable income even if interest rates rise.

But next year he forecasts sales of cars and light trucks dropping to 16 million, from 16.8 million vehicles last year. That might not sound much, but is equivalent to a more than $22 billion revenue cut. "That is the end of the world for a couple of automakers," Mr. Littmann said.

Negative equity is not the only threat as interest rates turn, because rate rises will have a direct impact on the profits of finance arms.

Analysts at Deutsche Bank estimate that a 1 percentage point rise in the Fed fund rate will lop $153 million from pre-tax profits at Ford Credit and $95 million at GMAC, as the cost of fund-raising on the bond markets rises.

However, rising rates have not always led to falling car sales, with an auto boom following the recession of the early 1980s as pent-up demand was released.

The current economic backdrop is also a comfort for carmakers: Rising disposable income, as the economy recovers, should offset much of the extra borrowing cost.

Both GM and Ford, the two largest US carmakers, are hopeful that better economic conditions will slow or even stop the price war that has sapped profits over the past three years.

Finally, rising rates will help deal with the single biggest burden faced by the U.S. manufacturers over the past two years: The enormous gaps in their pension and healthcare funding.

Every quarter-point hike in rates adds $1.9 billion to the accounting value of GM's pension fund, and cuts the $48 billion underfunding of post-retirement healthcare by $1.5 billion — reducing the combined annual cost by $270 million.

For Mr. Grand, the answer to negative equity and rising rates is simple enough: Drivers should keep their cars a little longer. But there is no sign that his customers are willing to face the facts.

"They say they're going to keep the cars until the wheels fall off," he says. "But they don't."

Copyright The Financial Times Ltd. All rights reserved.

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Data: Latest rates in the US

Home equity rates View rates in your area
Home equity type Today +/- Chart
$30K HELOC FICO 4.71%
$30K home equity loan FICO 5.26%
$75K home equity loan FICO 4.70%
Credit card rates View more rates
Card type Today +/- Last Week
Low Interest Cards 13.42%
13.42%
Cash Back Cards 17.94%
17.94%
Rewards Cards 17.14%
17.14%
Source: Bankrate.com