The Canadian Debt Conundrum
How to deal with the popularity of long-term loans.
Long-term loans first burst onto the Canadian scene between 2008 and 2012, with the collapse of leasing.
“Leasing was a huge part of the Canadian market,” says J.D. Ney, Director, Canadian Automotive Practice Lead, J.D. Power. “At the start of the recession, about 50% of new vehicle sales were lease deals. It went away almost entirely for a few years, and rather than accept a markedly higher payment, Canadians basically opted to extend the financing.”
Although leasing has returned to the Canadian market, accounting for about 30% of deals, long-term loans are on the rise. A recent J.D. Power study showed the number of 96-month term loans has been steadily increasing since 2017.
“Nobody buying a car in Canada today views that asset as being $38,000. They view it as being $492 a month,” says Ney. He sees a problem on two levels. “Eventually, it creates a bit of a bubble that takes people out of the car buying markets for longer than we have traditionally seen. And it opens up the window to cause some brand loyalty and brand affinity problems. If I have to own this product for eight or nine years, the chances that I’m going to experience some frustration with that brand are increased.”
Negative customer experience
There’s potential for a negative customer experience, in addition to the negative financial impact. “When you get back to the dealership to negotiate your next deal, you’ve got a mountain of negative equity based on two or three previous vehicles.”
Ney recommends offering customers a responsible deal, or at the least, pitching that type of financing and working through a monthly payment solution. He suspects that many dealers fear losing the deal if they show an initial monthly payment that may be higher. “The tendency is to show the lowest possible monthly payment, which is obviously derived from a 96-month financing term,” he says.
One of the culprits is the current low finance rate. “People would be much more reticent to sign up for 96-month financing terms if rates on those terms were high,” says Ney. “Today, a lot of those 96- or 84-month terms are coming at 0% financing. There’s an entire generation now of car buyers that only know extremely low financing terms.”
That said, Ney believes the car industry is in good health. “Technically, we’re into declining sales volumes but it’s really only half the story,” he says. “The volume mix is different today from what it used to be. It’s more like 75% light truck versus sedan which, for most manufacturers, is a more profitable sector. So we’re selling slightly fewer vehicles than maybe 2017, but each vehicle being sold is costing manufacturers much less in terms of incentive dollars, and it’s much more profitable.”
Average terms have always been a little longer in Canada because of buying power. “A vehicle in Canada costs more than it does in the U.S.,” notes Ney. “The vehicle purchase has always put a little more pressure on the Canadian household than in the U.S.”
According to Derek Sloan, Executive VP, Sym-Tech Dealer Services, the problem is a systemic one. “These terms are being offered by the lenders, and the lending institutions are promoting them as being an option,” he says. “How do you fix it? Lenders have to get tighter. They’re in the fee and the interest business, and as long as Canadians can pay, they can make profits.”
Sub-prime on the rise
Sloan sees sub-prime on the rise in the new car franchise world. “That’s happening predominantly because of the total debt service ratio, because the consumer has too much debt and is trying to pay off that debt, compared to how much income they’re bringing in.”
Sloan also notes that the luxury market has been on fire in the past five years. “Are people suddenly making a ton more money?” he asks. “What you’re having is people who want to keep up with their neighbours, who want a high-end car in their driveway, and they’re going to figure out a way, if the bank lets them, that they’re going to make that higher payment.”
He notes that some people even buy cars on their line of credit. “The average time it takes to pay off a vehicle through a line of credit is longer than 84 months; it’s crazy,” Sloan says. “It gets lost in all the other expenses you have on your line of credit. We’re a monthly payment society. We want the best stuff and we’re willing to extend ourselves to get it.”
The good news is that default rates have not changed in two years. “For 2018 and 2019, default rates have stayed pretty consistent,” says Sloan. “But debt has gone up and the millennials have the highest increase in debt year over year, over a 6.5% increase over last year.”
He believes the industry is in for interesting times over the next five years. “There’s so much experimenting going on with financing in general, on the automotive side,” says Sloan. “Down the road, we’re looking at subscription models, better lease models. We’re in very interesting times.”