New car sales are booming and that's good news for the economy. Auto plants are keeping workers busy and car dealers are thriving.
Since the slow recovery following the financial crisis new car sales have been one of the engines pulling the economy along. And while sales seem to go up every month, so do the prices consumers are paying to drive away in a new car.
The costs have risen so much that almost no one today pays cash for a car or truck – rather, they take out a loan similar to a small mortgage, both in size and length of term.
Experian Automotive reports the average dollar amount for both new and used vehicle loans reached record highs in the third quarter of 2014. The average loan amount for a new vehicle was $27,799 in the third quarter, up $1,080 from the previous year. People financing a used car purchase borrowed on average $18,576 – an increase of $676.
Average sale nearly $34,000
That's just the loan amount – it doesn't include the down payment. Kelley Blue Book (KBB) reports the average transaction price for cars and light trucks in November was $33,754. That's an increase of 1.7% over the same month in 2013.
"Rising transaction prices are a reflection of stronger pricing in truck and utility segments," said Alec Gutierrez, senior analyst for Kelley Blue Book. "Domestic automakers will be the main beneficiaries of this trend, as full-size pickup prices are up by an average of 4.3 percent, with the Big Three making up 94% of segment sales."
While vehicle prices have been going up, consumers' incomes have not. So, are consumers getting a bit over-extended on their automotive purchases? It's a question worth asking.
Longer loan terms
“Car buyers tend to shop with a monthly payment in mind. As a result, we are continuing to see them turn to leasing and longer loan lengths as strategies to keep payments down and make vehicles more affordable,” said Melinda Zabritski, senior director of automotive finance for Experian. “As car values continue to reach new heights, these insights will help dealers, lenders and consumers become more aware of the options available to them to keep people buying cars, all while staying within their budgets.”
The longer loan terms are a bit troubling. New vehicle loans in the 73 to 84-month – 6 to 7 years – range grew by 23.7% in the third quarter of 2014. Extra-long loans for used cars were up 18%.
Why it's a problem
This can be a problem several ways. A 7 year loan usually means the buyer can barely afford the payment. A financial setback here and there over the next 7 years and they could fall behind on their payments.
Some cars lose their value faster than others. Assuming you purchase a vehicle for more than $30,000 and pay a minimal down payment, at some point while you are still making payments the vehicle can be worth less than what you owe.
Because of ever-more-expensive vehicles more consumers have turned to leasing, which experienced explosive growth during the third quarter. Leasing went from being 7.1% of new vehicle financing in the third quarter of last year to 29.1% this year.
Leasing might well be a better option if your financing of a new car cannot conform with the 20/4/10 rule.
That rule of auto financing states that you should be able to make a 20% down payment, finance for 4 years and have the monthly payment that doesn't exceed 10% of your gross monthly pay. Let's take November's average transaction price $33,754 and use the rule to determine just how affordable it is.
Paying $33,754 would require a down payment of $6750. That means financing $27,004 for 4 years at a prevailing interest rate of 4%, giving you a monthly payment of $609.
To afford the average new car or truck, you would need a monthly gross income of $6090, or $73,080 a year. The average American household income in 2012 was $51,371.
One can only conclude that new car sales are rising each month because consumers are buying cars they really can't afford.