Zero Interest Rate Auto Loans, Term Paper Example

“Zero Interest Rate Auto Loans: Good or Bad for Consumers and the Auto Company?”

Introduction

US auto industry is the largest industry in the country in terms of manufacturing jobs, trade, R&D, and retail business. The US auto industry is also the world’s largest by automobile sales. For the year 2010, 4.8 million units have been sold in the first ten months and are expected to exceed five million units by the end of the year (Wall Street Journal, Nov 3, 2010). Wall Street Journal’s Nov 3, 2010 edition contains two charts that will be very helpful for the purpose of our analysis on “Cash for Clunkers” program at the end of the essay.

Chart 1.A shows that Japanese manufacturers Toyota and Honda have been steadily gaining US market share since October 2000 at the expense of US manufacturers GM, Ford, and Chrysler. During the same period, Toyota jumped two ranks to become the second largest automaker in the US by market share though Ford just recently claimed back its spot. Chart 1.B shows that the sales of last 12 months have been particularly good to GM and Ford and did not only help GM protect its leadership position but also helped Ford in regaining its lost spot. For the year 2010, GM’s and Ford’s YTD sales grew by 6.6% and 20.8%, respectively while Toyota’s and Honda’s YTD sales grew by 0.6% and 4.3%. At first glance, it may seem that the US Government’s ‘Cash for clunkers’ programs unfairly helped US auto manufacturers but as we are about to discover, the differences in the sales of respective manufacturers can be better explained by other factors that were at play.

Zero interest rate auto loans from a perspective of consumers.

What zero interest rate auto-loan means to consumer?

Zero interest rate auto loans enable consumers to finance the purchase of their automobiles without any interest penalty for a certain period of time. Even better, it helps reduce the real purchase price of the car because the principle is to be paid in installment over a certain period in the future without any interest component and as a rule, cash paid tomorrow is worth less than the cash paid today. Thus, the consumer not only gets to purchase an automobile with a lower deposit requirement but also gets to save money in the process. This may explain why zero interest rate auto loans are often accompanied with another option i.e. instant rebate. Rebate gives the consumer an instant discount in retail price for full payment.

Are they really zero interest rate? If they are do they really save money?

Theoretically, zero interest rate auto loans may still be zero interest rate loans but what matters to a consumer is the final purchase cost of the car. It is possible that the auto manufacturer or dealer offering the zero interest rate auto loans has already jacked up the retail price of the car in which case the higher purchase price would cancel any apparent savings on zero interest rate loans. There is another possibility in the previous scenario. Instead of jacking up the price of the car for the beneficiaries of zero interest rate auto loan, the manufacturer or dealer would simply give a discount for prompt payments since cash in hand is always preferable to cash receivables. A quick calculation may serve as a reliable check regarding the authenticity of zero interest rate auto loan. Let’s assume there are two automobile dealership consumers named Adam and Brian. Adam opts for zero interest rate auto loan financing where as Brian chooses to take advantage of instant rebate for prompt payment in full. If the present value of all installment payments that Adam is obliged to pay over the term of the zero interest rate auto loan equals the price after rebate that Brian is required to pay, then zero interest rate auto financing is real. But if the present value of Brian’s payments exceeds Adam’s after rebate purchase price, then either Brian is being charged implicit interest on his car financing or Adam was given a discount on his purchase. Either way, Brian’s zero interest rate financing didn’t really come free despite of what he is led to believe.

Another tactic may be the offer of zero interest rate auto loans over such a small period, resulting in high monthly payments. This would serve two purposes: first it would entice the consumers through the doors and second, since only a small proportion of the consumers would be able to fulfill the terms of zero interest rate auto loans so the majority will eventually end up paying interest penalties.

A careful study of the nature of zero interest rate auto loans reveals they are almost always aimed at the less affluent since those who could pay would most likely pay in full at once or within a very short period. If this is true, then the marketing tactics behind zero interest rate auto loans are not any different from the marketing tactics employed by credit card companies. Credit card companies often market 0% interest rate on balance transfers for a certain period (usually 12 months) and then make money by charging hefty interest rates since credit card companies know from their experience that most consumers always carry a balance for periods longer than those covered by the 0% interest rate deal.

Is customer really the king in the auto loans market:

Anyone who has ever shopped for both auto loans and personal loans may have noticed that auto loan terms are usually more attractive. This observation should not come as a surprise since auto loans industry is more competitive due to its national scope than personal loans industry which is more segmented in nature. A research report published in the January, 2005 issue of Journal of Business concluded that Leader-follower pricing behavior is morewidespread in auto lending markets than personal loans markets and auto loan rates also are less sticky than personal loan rates (Kahn, Pennacchi, & Sopranzetti, 2005, Pg. 132).

The intensity of competition is benefitting consumers. According to the data compiled by Informa Research Services and J.D. Power and Associates, between January 2009 and March 2010, the average rate offered to consumers with top credit (FICO scores in the range of 720 to 850) dropped to about 5.8% from 7.1%. During the same period, rates offered to consumers with middle-tier FICO scores (660 to 689) m 10.2% to about 9.4% consumers with credit scores below 660 saw a rise in rates from 12.9% to about 13.2% (Franchino, 2010, Pg. 33). This reveals two important changes over the last decade. First, the increased intensity of competition has given rise to even more competitive rates for the consumers. Second, the benefits extend only to consumers with high credit scores which means the financing intermediaries have tighten their loan underwriting standards to minimize the amount of bad loans. It is safe to assume that the above mentioned observations are being applied in the case of zero interest auto loans, too.

Auto manufacturers realize that the consumers have rising disposable incomes and ever increasing choices which shift even more power to the consumers than ever before. Auto manufacturers have responded by transforming financial deals to make it even more convenient for the consumers. One such shift has been the extension of financing term from 3 years to 5 years that significantly lowers the monthly payments for the consumers and expands the potential consumer base.

What consumers really want:

An investigative study published in the Journal of Consumer Affairs revealed some surprising facts about consumer preferences (Wonder, Wilhelm, & Fewings, 2008, Pg. 270). The study indicated that consumers prefer loans with low interest rates and moderate contract lengths. The most surprising finding was that even when choosing among interest-free loans, respondents do not prefer long terms, conflicting with traditional financial rationality. This is good news for auto loan providers since this means they can issue zero interest rate auto loans with shorter terms than is the norm in current business practices without having to worry about the potential negative impact on sales volume.

Zero interest rate auto loans from a perspective of auto companies/manufacturers.

Manufacturers sales strategy:

Zero interest rate auto loans may require strict credit score requirements that would shut out the majority of the potential consumers from the offer. But once a consumer has been lured in by the prospects of zero interest rate financing, he is already a candidate for aggressive selling tactics.

Zero interest rate auto loan as a sales booster is not a recent phenomenon. When the terrorist attacks of September 11, 2001 threatened to slow down economy, GM and Ford began offering no-interest financing on nearly all models and various other competitors including DaimlerChyrsler, Toyota, Mazda, and Suzuki etc. followed suit by offering no-interest financing on selected models (Gilligan, 2001). Automotive trend-watcher J.D. Power and Associates reported in October, 2001 that at more than 5,000 dealers in Richmond, VA, weekly saleswere up as much as 30 percent compared with a year ago. GM eliminated free financing the following year in April at the heels of strong sales. Sales hit 4 year low just a month later in May, 2002. The nation’s three big automakers bought back the zero interest rate financing in July to continue till September, 2002 (Welbes, 2002).

Most manufacturers introduce newer versions of their established models in the third quarter of the year and most auto loans are also issued in the same quarter. Thus, it may benefit the consumers looking for competitive rates on auto loans to wait until third quarters when auto makers feel the pressure to post strong sales numbers.

Zero interest rate and low rate auto loans seem to have become an important marketing tool in the arsenal of auto makers. Honda that has traditionally avoided following the suits of its competitors in offering low rate financing also jumped into the foray this year. Despite the fact that automakers hardly make any money on zero interest auto loans and other low interest auto loans, auto financing has become an increasingly important component of their overall operations. Making the matters worse is the fact that approximately half of all automobile purchases are financed in part or whole through auto loans. Even though the quality of the automobile products has been steadily increasing over the years, the consumers’ ownership duration has been decreasing. This means the frequency at which consumers purchase new cars or replace their existing cars has increased over the years. Thus, zero interest rate auto loans have become even more essential in defending one’s market share in recent times.

Financial Analysis

We have already touched upon certain aspects of financial statements but now we will carefully analyze other potential scenarios. The zero interest rate auto loans help reduce the inventory of the auto makers thus, improving turnover ratio and operational efficiency. It also increases cash receivables. It boosts up sales revenue as well as gross profits (atleast on the paper since it takes few years before a better estimation of bad debts emerges). It reduces P/E ratio by improving earnings which may make the stock price seem cheaper as compared to the competitors. The improved sales may also give boost to the stock price since part of the stock price reflects investors’ expectations regarding the future and good news often lead to optimistic expectations in the market which is why management is under pressure to respond to year to year market expectations, even losing sight of long term goals in the process.

But the company may actually jeopardize its long term financial health if it goes for aggressive sales campaign with the intent of revenue maximization. We have noticed that zero interest rate auto loans are usually employed in slowing economy when the risk of consumers’ default increases. This may lead to serious underestimation of bad debts which could jeopardize the very existence of the company. GM’s sale of 51% stake in its financing arm GMAC to Cerberus Capital Management is a good example of gross underestimation of bad debts and enforcement of loose underwriting rules to push inventory sales.

Thus, our final conclusion is that the zero interest rate auto loans strategy is an effective short term marketing strategy to push sales but it could be combined with services innovation to achieve lasting benefits. Moreover, it has the potential to overestimate revenue and profits and underestimate the potential of bad debts. The market for automobiles is highly competitive and operates on a national scale which shifts power to the consumers due to their ever increasing disposable incomes and rising product expectations. The quality of automobiles has been improving but the average ownership period has been decreasing which is good news for the automakers. Non captive financial intermediaries have already started competing on the basis of innovative services thus, it’s time that the auto manufacturers also start focusing on the service aspect of product experience. Lexus serves as a perfect example of an automobile brand that enjoys one of the highest customer retention rates in the industry on the back of extraordinary service despite charging premium prices for its products.

Cost of funds

Naturally, the sales boost from zero interest rate auto loans primarily comes from the consumers who might not have been able to purchase the cars otherwise either due to lack of funds or their inability to secure financing at attractive terms. Thus, liberal lending policies by the auto manufacturers increase the risk of loans going bad in the future. The analysis of credit bureau data shows that a captive automobile loan is less likely to be repaid than a bank automobile loan. This should not come as a surprise since captive auto loans have traditionally been issued under less stringent underwriting rules than bank loans. Money magazine reported in its July, 2003 issue that according to a recent Consumer Bankers Association survey, auto lenders hiked the average credit score required for a new loan from 668 to 716. As a result, loan-approval rates declined by five percent and the 48-point difference disqualified approximately 16 percent of Americans from the zero-or low-interest loans (Weisser, 2003, Pg. 29).

Auto manufacturers financing arms have been able to offer zero interest rate and other competitively priced lower interest rate loans because even if they incur losses on auto financing, they have an opportunity to make profits on auto sales thus, offsetting the losses on auto loans. This explains why financial intermediaries have difficulty in matching the auto manufacturers’ low financing rates.

The gain in customers through zero interest rate auto loans doesn’t come without costs for the auto manufacturers even though the costs may not directly affect them. Most auto manufacturers have financing subsidiaries for e.g. GM’s financing subsidiary GMAC, that often operate as independent financing units.  Thus, financing subsidiaries often approve loans even when they don’t make any money, just to ensure that the cars keep moving from the parent company’s inventory. The units do improve sales figures for the parent company but the organization as a whole suffers. This became apparent in the aftermath of recent financial crisis when GM was forced to dispose of a stake in GMAC due to heavy losses.

Receivables

One cost of zero interest auto loans is reduced liquidity and tie-up of a significant portion of assets in cash receivables. This also creates the tendency to overestimate assets, just like annual income, because bad debt estimates tend to be made liberally.

Impact on the loan asset value

It is also reasonable to assume that the sales boost achieved through zero interest rate auto loans may result in over statement of loan asset value as well as annual profitability. Almost all zero interest rate auto loans are multi-year term loans and it takes years to find out the true value of bad loans. Even though all auto financing arms maintain bad debt reserves but the reserves tend to be liberally estimated so as to minimize their impact on bottom-line profitability.

The role of financial intermediaries

For the sake of simplicity, the suppliers of auto loans can be divided into two main categories. First category is banks that would include all depository financial institutions and the second category is captive finance companies whose interests are not only dependent upon the loans they issue but also the underlying product that is being financed. Auto makers’ financing arms come within this second category. As is obvious, captive financing companies carry a natural advantage over banks and thus, banks have been striving to differentiate themselves on the basis of service quality instead of auto loan rates where they are at a disadvantage.

Zero interest rate auto loans have normally been the realm of auto manufacturers and have greatly boosted auto sales in critical times for the auto industry. This has not gone unnoticed by financial intermediaries. Case in point is a Winston-Salem, NC based Truliant Federal Credit Union (Daniel, 2008). Triulant started zero rate auto loans in 2007 to compete with the auto dealers. The company generated 1,650 auto loans and about $25 million, from May 1, 2007, to December 31, 2007. Triulant’s zero-rate auto loan allowed members to pay for all of their interest up front, thus, lowering monthly payments and finance costs. It also allows consumers to take advantage of manufacturer rebates that are not available to consumers of auto manufacturers’ zero interest rate auto loans. Moreover, manufacturers’ interest rate auto loans are usually only available on less popular, slow moving models, a restriction Triulant’s customers don’t face.

The advancements by credit unions and banks in the auto loan industry have not gone unnoticed by the financial subsidiaries of auto manufacturers either. By 2003, auto manufacturers had started taking measures to defend their market share even if it meant the sacrifice of profits on auto loans financing of their consumers. It seems their efforts are paying off and many small banks and credit unions have been gradually reducing the scale of their auto loans business. Many regional banks have admitted privately that it’s becoming almost impossible for them to compete with auto manufacturers’ financing arms and national financing networks (often used by dealers) that provide incredibly low rates to the automobile customers.

Auto loans are considered to have the most volatile rates of all types of consumer loans. It may be due to high levels of imbalances that often exist between demand and supply forces in the automobile industry. Whereas this volatility means uncertainty for the financial intermediaries, it can also be a great source of profitability in economic booms. The key to profits for financial intermediaries in both good and challenging times is to strike a delicate balance between underwriting controls and profitable segments of the market.

Zero Interest Rate Auto Loans: Opportunities for Consumers and the Auto Company       

US economy is increasingly becoming services oriented economy. Like every other industry, auto loan industry also has great room for innovation to profitably meet consumers’ needs by creating non financial value for them. Some of the ideas are presented below:

Build relationships with auto dealers: The criteria to qualify for zero interest rate auto loans have been rising over the years. Thus, the number of consumers who qualify for zero interest rate auto loans will keep declining over time. Thus, those consumers who don’t qualify for dealers zero interest rate auto loans may be referred to financial intermediaries, thus, creating a win-win situation for both the dealership and the financial intermediary. Auto dealers can be further enticed through commission payments for each successful referral.

Educate consumers: Most consumers don’t fully understand the details of auto financing and creating value by educating them will create goodwill for the financial intermediary.

Build custom financing deals for the consumers: Most auto financing offers by auto manufacturers come in limited forms. The sheer number of consumers offers a great opportunity for financial deal customization. The variables that are viable candidate for customization are down payments, loan terms, repayment periods, and so on.

Identify and target unmet needs: Most zero interest rate auto loans are offered on selective slow moving models. In addition, most zero interest rate auto loans are offered to boost sales when economy is struggling and ironically, this also means that the probability of loans going bad is going to be higher, too. All of these existing practices offer opportunity to meet unmet needs profitably such as offering low interest loans on popular models, extending zero interest loan offers even during boom times and so on.

Conclusion

We should not lose sight of the fact that zero interest rate auto loans will always be a temporary sales booster in the end. Part of the reason why zero interest rate auto loans keep coming back are the pressures that auto manufacturers face, like any other public company. Auto manufacturers are expected to meet annual sales projections and show sales growth otherwise their stock prices take a hit. It’s true that such short term focus on stock prices has the tendency to lose sight of long term goals but the top management of auto manufacturers like any other public company is usually judged on its ability to meet year to year expectations and their bonuses are often tied to annual performance targets. Zero interest rate auto loans can also hurt the manufacturers in the long run through over supply of specific models and reduced resale values. Zero interest rate auto loans may also cheapen the brand image as well as the quality perceptions of company products since good quality products are perceived to sell themselves without the support of any aggressive sales tactic.

Despite a disadvantageous position against captive finance companies, all is not lost for the banks or non captive financial intermediaries. Innovation in services always offers an opportunity to differentiate yourself from the competition and generate profits. Take the example of Puerto Rico based Reliable Financial Services, a wholly-owned subsidiary of Wells Fargo & Co. (Durand, 2006, Pg. A9). The company’s Triple Zero auto loan came with no origination fee, no cancellation penalty for prepayment, and no residual value upon termination. Reliable’s sales volume increased by 8-9% in the month of May, 2006 even though auto sales declined by approximately 50% and overall industry averages fell by over 25%.

Zero interest rate auto loans are a great short term marketing tool. But there are ways to take advantage of zero interest rate auto loans to yield long term benefits through innovative services. Zero interest rate auto loans increase the value of the product to the customer by saving him money. Some auto manufacturers have attempted to enhance public confidence in their products through extended warranties, often up to a period of ten years. This move was first popularized by Korean auto manufacturers and has been instrumental in helping Hyundai and Kia gaining market shares in the US auto market. But extended warranties also do not come without costs for the manufacturers even though the warranty costs may be outweighed by increasing profitability.

Zero interest rate auto loans can also be used in the same manner, even in the place of extended warranties. They may yield both short term and long term advantages if the struggling auto manufacturers can greatly improve the quality of the products. Lexus brand is renowned for its high customers’ retention rates because customers have such a satisfactory experience with Lexus products quality that they keep coming back when the time comes for replacement or additional purchases.

So far the zero interest rate auto loans have been primarily used to gain temporary sales boost, often without sufficient underwriting controls that resulted in greater than expected bad loans. Captive financing companies hold an obvious advantage against their non-captive competitors because they have two profit avenues available to them. Non captive auto loans providers have been quick to realize their disadvantage and have been working to differentiate themselves on the basis of value added services.

Now we come to the significance of the charts presented at the beginning of this essay. The charts show a somewhat better current year for the US auto manufacturers as compared to their Japanese counterparts. At first glance, one may suspect that US based auto manufacturers got help from the US Government’s ‘Cash for Clunkers’ program but this assumption could not be farther from truth even though a minor portion of sales could be attributed to it. But it should be noted that ‘Cash for Clunkers’ program was not exclusive to US auto brands. Even foreign auto manufacturers products were also eligible for it though more US auto manufacturers benefitted from it as compared to the foreign auto manufacturers.

The irony of the ‘Cash for Clunkers’ program is that the negative characteristics of the US auto products turned out to be an asset under the program. Most vehicles that exchanged hands had lower resale values than the amounts offered under the ‘Cash for Clunkers’ program. Foreign auto products especially Japanese and German automobiles tend to hold higher resale values over time than their American counterparts. Thus, few owners of the foreign automobile brands found it profitable to benefit from the ‘Cash for Clunkers’ program. Foreign automobiles, especially, Japanese automobiles sell at higher retail prices than their American alternatives even when they both are in the same vehicle class, have similar features, and assembled in the same country. Vehicles with lower retail price sold in a greater quantity under the ‘Cash for Clunkers’ program. American auto manufacturers also provided zero interest rate loans and other attractive financing options on more model lines than their foreign counterparts which may also have given some sales boost. This explains why 2009-2010 has been a banner year for the US auto manufacturers and how ‘Cash for Clunkers’ program unintentionally benefitted US automakers more than their foreign counterparts even though the program didn’t exclude anyone.

References

Daniel, F. (13 May, 2008). Paying Less: Zero-percent financing for auto loans reduces the total amount to be paid. Winston-Salem Journal (NC)

Durand, A. (29 June, 2006). Reliable Financial offers the Triple Zero auto loan. Caribbean Business , p. A9

Franchino, V. (2010, May). Cars Wars. Credit Union Magasine , pp. 32-37

Gilligan, G. J. (13 October, 2001). Virginia Dealers, Buyers Back on Track As Zero-Percent Loans Boost Auto Sales. Richmond Times-Dispatch (VA)

Kahn, C., Pennacchi, G., & Sopranzetti, B. (2005, January). Bank Consolidation and the Dynamics of Consumer Loan Interest Rates. Journal of Business , p. 132

Wall Street Journal. (3 November, 2010). Auto Sales – Markets Data Center. Retrieved November 20, 2010, from http://online.wsj.com/mdc/public/page/2_3022-autosales.html#autosalesB

Weisser, C. (2003, July). Auto Loans. Money , p. 29

Welbes, J. (3 July, 2002). Zero-Percent Auto-Loan Financing Returns. Saint Paul Pioneer Press (MN)

Wonder, N., Wilhelm, W., & Fewings, D. (2008, Summer). The Financial Rationality of Consumer Loan Choices: Revealed Preferences Concerning Interest Rates, Down Payments, Contract Length, and Rebates. Journal of Consumer Affairs , pp. 243-270