One of the first things you often hear when someone purchases a new car, is them describing the new car smell.  More people get to explain the nuanced aroma as auto sales increased double digits for August 2012.  While this is great news for the auto industry, it is interesting to ponder how this is possible given the state of the economy.  Have people been delaying car purchases and it finally culminated with improved sales this past month?

While it certainly is not the only factor, a major contributor is credit, which is flowing more freely.  Low interest rates coupled with long repayment terms allow people to afford the monthly payment on a new car.  In fact, the average new car loan has a term of 65 months (5 years and 5 months).  Some lenders are offering car loans as long as 7 years!  The chart below shows new car financing by term and the year-over-year change between Q1 2012 and 2011.  This clearly illustrates the gravitation towards longer repayment terms.

By stretching out the loan payments, consumers are paying significantly more in interest over the life of the loan.  Assuming you can get the same interest rate for both 4 and 7 year car loans, the 7 year vintage will result in the consumer paying 75% more in interest over the life of the loan.  Of course the enticement is a monthly payment on the 7 year loan that is 41% lower than the 4 year loan.  Longer maturity auto loans almost always carry a higher interest rate, so this comparison actually underestimates the costs.  Furthermore, new cars rapidly depreciate and stretching the payment out over 7 years causes owners to grapple with negative equity.

This segment of the marketplace illuminates an interesting aspect of human behavior.  The numbers clearly point to the high cost of this decision, but demand is present for extended maturity auto loans.  More people able to get into a new car with this structure, but the decision appears shortsighted.  How bad do you want the smell of a new car?

Source:

http://www.experian.com/assets/automotive/white-papers/2012-q1-state-of-automotive-financing.pdf