Underwater: Consumers Are Treating Cars A Lot Like Houses During The Subprime Mortgage Crisis
Auto dealers, car buyers and vehicle salespeople are treating cars a lot like houses during the last financial crisis, piling on debt to the point where the debt often exceeds the car’s value.
It’s a phenomenon known as being underwater — or negative equity — and it can leave car owners trapped, Wall Street Journal reported.
In two years, John Schricker took out four auto loans, each time trading in the last car and rolling the unpaid balance into the next loan. He recently bought a $27,000 Jeep Cherokee with a $45,000 loan.
Underwater loans happen more often among subprime borrowers, partly because people with lower credit scores often cannot pay off the remaining balance on one car loan before buying the next vehicle.
Carrying higher interest rates than comparable prime loans, subprime auto loans became big business in 2001 to 2004, along with subprime mortgages. Banks had so much money to lend that they sought out the higher returns from charging higher interest rates to higher-risk subprime borrowers. After the subprime mortgage crisis of 2007 and 2008, subprime lenders thinned out, but they have been making a comeback.
A third of people who traded in cars to buy new ones in the first nine months of 2019 had negative equity, compared with 19 percent a decade ago, according to car-shopping site Edmunds. Those borrowers still owed $5,000 on average before they took on new loans, WSJ reported.
Cars are getting more expensive and lending standards are getting easier, perpetuating the cycle. Lenders often approve seven-year loans or more with little or nothing down.
Borrowers are usually trading in their vehicles because they have to. Sometimes the vehicles have problems. “These aren’t Rolls-Royces,” said David Goldsmith, a lawyer who defends consumers in auto cases. “They’re Ford Escapes.”
Not everyone can afford the luxury of paying cash for a car — even a crappy one. But that’s exactly what Jared Dillian, a former head of ETF trading at Lehman Brothers, is advocating.
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Dillian, now an investment strategist at Mauldin Economics, is a big fan of cheap cars paid for with cash. “A car can bankrupt you. Or you may get to watch helplessly as it gets towed out of your driveway. And don’t get me started on leasing, the extended warranty of auto finance,” Dillian wrote in a June 2019 Market Watch column.
The ideal scenario, Dillian said, is “Get a gently used Toyota, pay cash, drive it forever. You win the personal-finance game.”
Entrepreneurs, investors and car nuts weighed in on the question of new vs. used cars on Quora.
- Glen McMillian, old gearhead and mechanic on old cars and trucks: “I know a dozen or more people who never earned big money but still got to be millionaires by way of living modestly and saving and investing their money long term. As a rule, if they do buy a new car, it’s not an expensive model, and they drive it a long time, 10 years or longer. New cars are extraordinarily expensive status symbols, when you get down to the nitty-gritty. It’s not just depreciation eating your money, it’s taxes, finance charges, and full coverage insurance premiums.”
- J.P.W. Gordon, attorney: “Cars are often one of the biggest reasons why people who have “money,” go broke. They’re often perceived as status symbols, practically always depreciate, and when you’re new to money, you often buy some of the biggest/fastest, and most expensive car to maintain. It’s all about attitude, just because you can afford a nice car, do you want to spend the bulk of your money on them?”
- Gordon Miller, entrepreneur and investor: Yes, the sweet spot in price versus value is 2–3 years old with less than 30,000 miles. A car can lose up to 30%-40% of the initial value over the first 3 years. Most millionaires pay cash for everything and never finance so a $60,000 car that they can buy for $40,000 offers real value. I can also say that having had 54 cars in the last 27 years, the best deals I have done have been on used cars.
“You should have $1 million before you buy a new Beamer or a Benz,” Dillian wrote for Market Watch.