The Upside-Down Blues

When an issue makes the front cover of Automotive News, the Bible of the car industry, you can bet it has gravity, and the phenomenon of being "upside-down" in a car loan reached that status last week. The trade publication described the growing number of consumers who owe more on their loan than their vehicle is worth -- the simplest explanation of the term "upside-down" -- as "an industry time bomb." It just couldn't predict when that time bomb would explode, but with interest rates predicted to climb over the next several months, it could be sooner rather than later.

Before we discuss what effect the overall phenomenon might have on the car industry and the American economy as a whole, let's look at how it affects individual consumers.

Most consumers find themselves upside down for a simple reason -- the pursuit of the lowest monthly payment possible. There was a time when the "standard" auto loan was just two years (24 months.) Then, as cars grew more expensive and lenders grew more lenient, loan terms stretched to three years, and four years, until now, some industry data suggests the average car loan term is 63 months -- more than five years!

At the same time, down payments have shrunk from an average of 20 percent back in the deep, dark past to less than five percent today. In just the last decade, they have diminished from 15 percent of the purchase price, and "factory cash" often subsidizes even the five percent down payments being made these days. If you have no money at all and just mediocre credit, you can probably "buy" a $20,000 new car this afternoon.

Because of the long payment cycles and small down payments, a vast majority of buyers have just a tiny amount of equity (real ownership) of their cars. Instead, for most, the finance institution is the actual owner. All of which would be essentially transparent if car buyers held their vehicles until they were paid off. But they don't.

Consumers who are carrying a five-year loan will frequently walk into a dealership after, say, three years and want to buy a new vehicle. This is where the problem surfaces, because very frequently these days -- some experts say 30 percent of the time -- that consumer will find, to their great dismay, that they owe more money on the vehicle than it is worth as a trade-in. And to buy a new vehicle, the first hurdle is to get clear of that old debt, which Edmunds says now averages $3,700.

What happens next? Well, logic might suggest that the prospective buyer backs off from getting a new car and holds onto the old one at least until it is paid off. But logic and car dealerships rarely walk hand-in-hand. What the typically solicitous car salesperson does in this situation is help the consumer by suggesting that she or he "roll" the accumulated debt on the old vehicle into the about-to-be-established loan on the new vehicle.

In a recent example cited by Automotive News, a Texas Chevrolet dealer signed a customer to a $47,000 96-month (eight year!) loan on a big SUV, a loan that was for some $15,000 more than the value of the vehicle the customer was buying. That's called going from upside-down to UPSIDE-DOWN.

The result of all this is that individual consumers will keep falling deeper and deeper into debt until they find bankruptcy the most advantageous course of action. Then the financial institutions holding the paper get burned -- and those of us who spend within our means and pay our debts get burned by higher interest rates and higher loan fees to help compensate from the bankruptcies and repossessions that will inevitably result from this more-debt merry-go-round. The auto industry, which now seems to be fueling the upside-down trend, would also be a casualty because as finance companies rein in their loan practices in response to more and more defaults, as fewer people will qualify to buy new cars.

Driving Today Managing Editor Jack R. Nerad is the author of The Complete Idiot's Guide to Buying or Leasing a Car. He speaks and writes frequently on car-purchase issues.