Economic Realities

Escalating prices, spawned by the rapid evolution of new vehicles, have affected the buying process.

Twenty years ago, the average duration of a new car loan was just under 35 months. Today it's over 56 months. Longer financing periods have helped consumers keep their monthly car payments in line with household incomes and budgets. But over time, they have also had a negative impact on sales because they have tended to keep buyers out of the market longer between purchases.

Long financing periods mean that it takes buyers longer to establish equity in their vehicles. Equity can be defined as a positive difference between the value of a vehicle and any loan amount outstanding, which for most means "trade-in value."

When the average financing period was three years or less, the typical buyer's equity would be equal to about 40% of the price of the average new car on a three-year trade. With today's average term approaching five years, the average buyer may in fact still be "upside down" in the loan at the end of three years. Which is to say that he or she owes more than the car is worth.

In order to get "rightside up," buyers have to pay longer, and, when they've finished, their equity position relative to a new car will obviously be less because their vehicle is older. On a five-year trade, today's average buyer has equity, but only equal to about 20% of a new vehicle. And while most like their cars, many would prefer a new or different one more often than once every five years. Manufacturers are very glad they do. But since cars aren't getting any less expensive to make and consumer incomes aren't rising or keeping pace, manufacturers have been faced with a genuine dilemma in their efforts to make this a reality.

Rebates

Rebating was originally conceived as a marketing tactic to distract consumers from the shocking sticker prices which started appearing in the 1980s. It worked, but it also did something else.

Rebate checks could help make up for equity deficiencies that consumers might be facing in their current car and financing contracts. As such, rebates helped sell new vehicles by helping consumers to buy their way out of their old ones. This is why many manufacturers have adhered to rebates rather than simply lowering the prices.

In terms of stimulating sales, rebates have been proven effective, but they have downsides. Among these is the fact that rebates can work against the building of owner equity. For one thing, rebates are often applied to the money owed on the car traded in, rather than the one bought. Rebates also tend to depress used-car prices, which in turn reduces trade-in values--the basis of most buyers' equity on either end of a deal. What's more--regardless of what a manufacturer intends or how rebates are used--consumers perceive them to be discounts. And discounts imply "distressed merchandise," which undermines consumer perceptions of quality and value.

The obvious futility of the above scenarios has caused the industry and consumers to rethink the buying and selling process.

Leasing

In 1990, Leasing accounted for 12% of all new vehicle transactions. It's expected that this will have risen to about 25% during 1993 and, by 1996, leasing could account for as much as 50% of all new vehicle transactions.

Although leasing is a simple, logical alternative to traditional financing, it is often misunderstood. To best understand automotive leasing, first forget any preconception based on experiences such as "leasing an apartment."

When you lease an apartment you are utilizing something--a space--whose value is not likely to be diminished or depreciate through your use. This is why it is extremely rare for a landlord to reduce the rent upon renewing a lease.

By contrast, most motor vehicles are presumed to have finite useful life. At the moment, the median age of all cars on the road in the U.S. is only about seven years. This is not to say that a car over seven years old is useless, only that cars, trucks and vans do wear out. This is why newer ones are worth more than older ones (unless they're classics).

When you purchase a vehicle, the amount of money you pay is presumed to represent all the value that the vehicle may have over its entire useful life. If and when you ultimately sell ot trade in that vehicle, the amount of money you receive for it should represent what remains of its total original value (what you haven't used). Therefore, what you have actually paid for-after you deduct the resale amount-wasn't the whole car, but some portion of its useful life.

This is exactly what happens in a lease-with one major difference. In a lease you decide and you agree-upfront-exactly how much of a vehicle's useful life you wish to purchase. And that's what you-as the lessee-agree to pay for.

LetXsXsayXyou(XeXect X Xew (ehXXle which could be purchased out- right for $30,000. But you know you intend to drive it for only three years. Based on market experience and conditons, the lessor calculates that three years of it's use for this particular vehicle might represent 55% of its total value. Your lease would thus be based on 55% of $30,000 or $16,500. So who's going to pay for the other 45% or $13,500? Initially it will be the lessor, which can be the manufacturer, the dealer, a bankor a leasing company.

When a lease is based on a pre-determined residual value, it is called a "closed-end" lease. A closed-end lease may also give the lessee the option to buy the vehicle at the end of the lease at its residual value. There are also "open-end" leases, which are based on an estimated resiudal value, with the lessee (you) agreeing to make up for any shortfall in residual value or taking any excess at the end of the lease. Open-end leases can mean lower payments, but generally not worth the risk.

In the typical closed-end lease, the lessor is obviously assuming a considerably risk. Not of the possiblity that you might wreck the vehicle, tuXn it in in bad condition or with excessive mileage--these will be your responsibilities and they will be stipulated in your contract or lease agreement. The lessor's risk is on the vehicle's market or residual value at the end of your lease. And for taking this risk off your shoulders, the lessor will probably expect you to pay a premium.

At a minimum you can expect to pay interest-- not just on the amount of money that would cover the portion of the vehicle's life or value that you intend to use, but on its net purchase price or capitalized cost. Thus, if you were to lease this vehicle for three years, you would probably end up paying at least the same amount of interest as you would did you were to purchase it on a conventional three-year financing contract, plus paying for the part you would be leasing (actually purchasing), which would be 55% of the vehicle's total value.

In a leasing arrangement, the non-interest portion of your payments would be based on a lower principal amount (in the above case $16,500 instead of $30,000) and it may seem that the only advantage of leasing is a lower monthly payment. In theory this is true. But in practice--particularly in a down or highly competitive market--leasing affords manufacturers many opportunities to adjust prices and cut better deals without having proclaim a huge rebate or embarrassing discounts. This is why so much of the advertising you see today is for leasing.

When the lease is offered by the manufacturer or a captive financing arm, the manufacturer can, in effect, discount the price of a new vehicle by increasing or subsidizing its estimates residual value. It can also discounts the interest rate it charges on the purchase price or capitalized costs. Or it can choose to base interest charges on some percentage of the actual capitalized cost. The point is, when it's more important to move vehicles than it is to make money on financing, manufacturers can and do come up with money-saving inducements for the consumer. Leasing may not be for everyone and it may not always be an economical alternative to purchasing. But in today's market there are some genuine deals to be had. The problem is finding them and deciding if leasing is right for you.