What would happen if lenders made certain assumptions about asset values and took advantage of low interest rates to offer friendlier loan terms so borrowers could more easily finance purchases they wouldn't be able to afford otherwise?
One risk is another 2008, when the U.S. housing market, propped up by creative mortgages, collapsed in spectacular fashion, sending shock waves across the global economy.
Another scenario is the one now playing out in the auto market, where, despite stagnant personal incomes, the auto industry is able to command both rising sales and higher transaction prices by extending loan terms to five, six and even seven years, making monthly payments more manageable.
Auto and finance executives acknowledge that this trend has risks, namely that the abundance of extended-term financing could cause a future slowdown in the auto market as shoppers ride out longer loan terms before returning to the market.
But for now, they see that risk as limited. Executives say that strong used-car values, low interest rates and automakers' greater discipline in managing production and incentives point to a more sustainable recovery in auto sales and lending, even as consumers increasingly opt for car loans that will take more than half a decade to repay.
"There is good discipline across the industry, and everyone is doing what it takes to manage their business appropriately, and it's nothing like what we saw prerecession," said Thomas King, senior director of the J.D. Power and Associates' Power Information Network.
"There is, of course, risk for the long term," King says of the growth in extended-term loans, "but that risk in magnitude is very small."
|Q1||AvG. Loan term|
|Source: Experian Automotive|
72: The new normal
The average term of new-car loans in the first quarter of 2014 was 66 months, up one month from the prior year and the longest average term Experian Automotive has on record. At the same time, loans with more than five-year repayment terms accounted for 66 percent of all new-car loans.
"Over the past several years, 72-month-term loans have become the norm for auto financing," said Melinda Zabritski, senior director of automotive credit at Experian Automotive.
Loans ranging from 73 to 84 months jumped 28 percent in the first quarter, accounting for a quarter of all new-car loans, according to Experian, while all new-car loans ranging from 25 months to 72 months declined.
PIN's King says that growth is partly "a natural consequence of those folks that were excluded from the market who are now returning and using these loans" -- specifically, younger, first-time new-car buyers or those with unfavorable credit who until recently were unable to obtain financing.
Longer loans also enable customers of all credit profiles to obtain lower monthly payments, which in the current environment of historically low interest rates and record-high vehicle transaction prices is a strong proposition, King says.
Both Zabritski and King acknowledge a theoretical risk with longer-term loans: This growing segment of buyers will delay their next vehicle purchase until their six- or seven-year loans are repaid, slowing the replacement cycle and bringing the current sales recovery to a crawl.
"That's the one thing that everybody's focused on," King says.
At the moment, that risk looks minimal. For one thing, King says, the growth in six-year loans doesn't reflect a broad shift from short-term to long-term financing.
"We're really talking about people adding on an extra 12 months on a new-vehicle purchase cycle," King says. "The extra 12 months isn't going to have a huge impact on your equity position."
For another thing, he says, the growth in extended-term financing has coincided with a surge in leasing, meaning that those longer payoffs are balanced by more off-lease customers returning to the market after three years. "That's a good structural thing," King says.
And long-term borrowers don't necessarily withdraw from the market for the entire loan term. The critical factor here, says Hyundai Motor America CEO Dave Zuchowski, is the customer's equity in the car -- or when the car's market value is more than what's outstanding on the loan.
Right now, customer equity is being protected in part because manufacturers are being more prudent about tailoring their production to meet demand, which boosts resale values. That, plus low interest rates, helps customers reach equity in their vehicles more quickly.
Lenders and dealers have become more sophisticated in figuring out when to pitch borrowers on turning that equity into trade-in currency.
"On a 72-month loan with the kind of rates we're seeing now, with 0.9 percent or 1.9 percent, that customer is in an equity position somewhere around the 42nd or 44th month of the loan, depending on the kind of car," Zuchowski says. "So just like for [an off-lease customer], the dealers and captive finance sources are getting very good at identifying customers in equity."
That said, industry executives say they are paying close attention to the industry's customer loan portfolio for signs of trouble, exercising the kind of scrutiny that didn't happen enough during the housing bubble.
One metric Zabritski watches closely is the rate of auto-loan delinquencies, which she says is holding steady at below prerecession levels.
However, 22 states posted an increase in 60-day delinquencies in the first quarter of 2014. Despite those gains, Zabritski says, delinquency levels overall are not currently a cause for concern.
Nationally, 60-day delinquencies dropped slightly, by about 2 percent, in the first quarter vs. 2013; 30-day delinquencies fell 5 percent.
"We're not yet seeing a rapid increase in delinquencies," she said. "Consumers are doing an excellent job managing their debt load."
Interest rates are the test
Bruce Jackson, head of retail lending for Chase Auto Finance, says the growth of extended-term financing is part of a broader return to a lending environment that's more like what it was before the 2008-09 financial crisis but with far less dangerous loan-to-value ratios.
"Consumers have remained prudent. Lending institutions have remained prudent," Jackson said.
The real test for the auto finance market will be interest rates, which are broadly expected to rise in the next two to three years. Higher rates will challenge consumers' ability to keep monthly payments low, PIN's King says, which could steer more of them toward less expensive or used vehicles.
Still, Jackson says interest rates aren't likely to rise much unless policymakers have confidence in the strength of the recovery. Rising rates, he says, would indicate stronger employment and incomes and consumers who are on stronger financial ground.
"We're in a historically low interest rate environment right now," Jackson says, "and I'm a true believer that when [interest rates increase], it'll mean that the economy is better."