Canadians worried that the recent rise in interest rates might mean the end of zero-percent financing and super-low interest rates on their vehicle loans shouldn’t be too worried, according to experts.
Though lending rates for prime borrowers went up from 2.5 percent to 2.85 in the past 12 months and rates for non-prime borrowers increased from 7.5 to 8.4, Michael Buckingham, Senior Director of JD Power’s Power Information Network Auto Finance Group, believes that intense competition for car buyers amongst the automakers and a strong Canadian economy will keep financing rates low.
“In some instances you’ll see slight rate increases charged to consumers, but I think in this environment where there are a lot of incentives that the manufacturers are employing, they’ll still continue to have a lot of low interest rate schemes; the manufacturers are probably going to absorb more than what the consumers are,” says Buckingham.
Dennis Desrosiers of Desrosiers Automotive Consultants, agrees: “Since most vehicle companies sub-vert interest rates in some fashion, in the early stages of rising interest rates the vehicle companies typically find ways to absorb the cost of any increase and try to protect the consumer from some, if not much of, the effect.”
“The industry is in a period of transition trying to continue the robust sales pace of the past few years and coping with the escalating costs of maintaining the level of consumer incentives that contributed to that result,” said a Honda Canada spokesperson. “While it is logical to believe some of those costs will be passed on to consumers and that they (consumers) will absorb the impact by transitioning to longer terms, competition will dictate the extent of this market reaction. Honda has no plans to lower its sales expectations for 2018.”
Margaret Mellot of Ford Motor Credit Company Communications believes that positive economic factors will compensate for any interest rate increases: “We expect that interest rate increases would accompany stronger employment, consumer buying power and other positive economic factors. Modestly higher rates could be absorbed and not significantly affect monthly payments.”
Michael Hatch, Chief Economist with the Canadian Automobile Dealers Association is also confident that rising rates won’t deter car buyers in 2018. “I don’t think, in the short term, slightly rising rates will have a large impact on vehicle sales. It is possible they will have an impact on the mix of vehicles people purchase, but for the most part a consumer that needs a new vehicle will be in the market, regardless of what rates are doing in the short term. Also it is important to note that rising rates don’t happen in a vacuum – they are the result of strong economic and job growth, both factors that have been driving record vehicle sales for five years now.”
Dennis Desrosiers points out that there was very little negative impact from rising interest rates last year. “Canadians bought all-time record numbers of vehicles,” explained Desrosiers. “In addition, most vehicles sold in Canada are imported so exchange rates play a significant part of pricing. If the Canadian dollar strengthens it would offset some of the effect of rising interest rates.”
Canadian light vehicle sales in 2017 reached a new record of 2,038,798 vehicles, but sales in November and December 2017 decreased slightly from levels a year earlier. JD Power’s Buckingham doesn’t believe that was due to higher interest rates. “There’s a few factors involved: the softening of car sales vs trucks, dealer inventory levels, and possibly the dialling back of incentive levels from some manufacturers. Weather can also be a factor.”
Rising interest rates certainly didn’t affect the hot pace of Canadian vehicle sales in January. Overall light vehicle sales were up by 5.7 percent, according to Desrosiers.
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However, not everyone is confident that rising rates won’t make a difference for vehicle purchasers in 2018. Carlos Gomes, Senior Economist and Auto Industry Specialist with Scotiabank believes that Canadians increasing debt obligations may hurt vehicle sales this year. “While balance sheets remain healthy for most households, rising interest rates will also squeeze the finances of some consumers and will have some dampening impact on auto sales. We expect the Bank of Canada to increase its benchmark short-term interest rate by 75 basis points in 2018, raising the debt service burden.”
It’s not just rising rates for car loans that could affect vehicle purchasers: mortgage rate increases and interest rate increases on other consumer products could place an additional burden on Canadians, perhaps forcing them to cut back on their vehicle purchases.
According to Gomes, in late 2017, debt charges (mortgage and interest payments) absorbed only 6.7 percent of personal disposable income, below the average of more than 8 percent of the past two decades. “However, the debt service ratio bottomed in late 2016, and will move gradually higher going forward,” he notes.
Gomes says employment and economic growth are projected to moderate in Canada over the coming year, with payrolls likely to expand by roughly 1.5 percent, below last year’s pace, but still above the average annual increase during the current economic expansion. “Slowing employment growth will likely be the main driver behind an expected moderation in auto sales to 2.0 million units this year, from a peak of 2.04 million in 2017,” predicts Gomes.
Ken Maisonville, Director of Sales, Product and Corporate Strategy at Hyundai Auto Canada believes that higher rates may impact the types of vehicles consumers buy over the longer term. “If consumer buying power is affected by higher costs to service their debt in the broader economy, a move to less expensive vehicles may become one result we see.”
Honda Canada anticipates little change in the luxury market but sees a possible change in the preferences of mainstream buyers. “We may see […] a slight shift back to compact vehicles as we’ve seen in similar market conditions in the past. Cost-conscious consumers are more likely to look for vehicles that offer strong fuel economy, dependability, and versatility – like the Honda Civic – while still being able to meet their daily needs at a price that fits their budget.”
JD Power’s Buckingham is a little more optimistic: “Some consumers may spend a little less on their vehicle purchase, may not get the deluxe model, maybe not get as many options,” he says. “Some buyers may be attracted by late-model used cars. In the US and Canada, we’ve seen a lot of late-model, high-quality used cars coming off lease that have attractive pricing.”
Michael Bouliane, Manager, Corporate Communications, External Affairs, Toyota Canada doesn’t think Toyota and Lexus customers will switch to cheaper new vehicles or used cars if rates rise. “We’re forecasting the 2018 new vehicle market to be very healthy and comparable to record-breaking sales in 2017. We don’t anticipate that any interest hikes will change the vehicle preference of consumers.”
Buckingham points out that a small rate rise on a car loan amounts to relatively little over the course of the loan. “When you look at what a half a point on an interest rate is over 72 months, you’re not talking thousands of dollars in the life of the car loan.”
To keep monthly car payments low, lenders have been offering longer and longer loan terms. According to JD Power, the average length of a vehicle loan financing term (called the amortization period) in Canada is averaging 71 months, but in the last 12 months, approximately 54 percent of all the loans had terms of 84 months or greater. The average lease term averaged 48 to 49 months.
Longer loan terms can create financial hardship, warns Lynne Santerre of the Financial Consumer Agency of Canada. “Long-term car loans with terms 72 months or more are often more costly than traditional loans, typically 60 months, because consumers have to pay interest for a longer period than they would with more traditional term loans,” she says. “And long-term car loans can make consumers more vulnerable to financial risks in the event of an economic shock, such as job loss, illness, or accidents. If consumers need to break a long-term car loan early because they are no longer able to make their payments, then they may need to raise additional money to make up the difference between what the car is worth and the outstanding loan balance.”
Analysts don’t seem to be worried that higher interest rates will encourage even longer loan terms. “With the banks perhaps, but with the captives (manufacturers, dealers, third-party lenders) more than likely ‘no’,” says Buckingham. “They’re concerned about the consumers coming back. All lenders and dealers don’t like the long terms, but in order to sell and finance cars, they’ve realized that they depend on longer terms, especially as vehicle prices continue to get higher.”
Toyota Canada’s Bouliane concurs: “We don’t see term preferences of consumers changing with any change in interest rates.” Toyota Canada currently offers finance rates up to 84 months and lease rates up to 60 months.
Buckingham thinks Canadian consumers are becoming more risk-averse to long-term car loans anyway. “Awareness among consumers about the risks of longer terms has increased,” he says, “in part due to a special investigative report aired by the CBC last year.”
As always, a buyer’s credit history plays a big role in determining their loan rates. Those with a good credit history and a credit score above 650 (prime buyers) will likely qualify for lower interest rates while those with little credit history or a poor credit rating (sub-prime) will be charged higher rates.
Higher interest rates will create additional financial strain for those with negative equity, so-called “underwater” buyers, warns Santerre. “Canadians continue to trade in new cars after four or five years, putting them in a position where they owe more money on their loan than the car is worth (negative equity), which leads them to finance old auto loan debt into their next car loan, and their next car loan will likely have a higher interest rate.”
JD Power recently estimated that the percentage of Canadian car buyers trading in vehicles with negative equity was averaging 28 percent. Still, Equifax estimates the average delinquency rate for new car loans is only about 1.9 percent.
In the short term, most industry analysts feel that the borrowing climate will be sunny for most car buyers. “We’re still, relatively speaking, in a low-interest environment, and in general, the Canadian economy is in good shape. Keep in mind that rising interest rates are really reflective of a stronger economy. That’s the thing about interest rates, when the economy is good, interest rates tend to go up, but when the economy is not doing well, governments set lower rates to spur business,” says Buckingham.
But for the long term, analysts are more cautionary. “If rates continue to rise, it eventually has to be passed onto the consumer with higher costs of borrowing,” says Desrosiers.
“Make no mistake, higher interest rates will eventually negatively impact vehicle sales.”