Economy and capital markets
Rise in LIBOR Means Increased Debt Costs for Dealers and Their Customers
Dealerships have benefitted greatly from record-low interest rates in the last several years. But we’re currently seeing an aggressive change in short-term interest rates. These higher rates could potentially drive up expenses for dealers and consumers.
Most outstanding loans are priced on a risk spread to an index, the London inter-bank offered rate (LIBOR), or prime rate. The summaries and charts below show the sharp increase in both LIBOR and federal funds in the past 12 months — and what that means for dealers and their customers.
LIBOR increase cutting into dealerships’ profitability
LIBOR is the rate that banks charge each other in London for overnight loans. More than $350 trillion of financial instruments are benchmarked to LIBOR globally. The instrument that most loans are tied to is the three-month LIBOR, which has increased more than 2 percent in the past 24 months (see chart #1). This, in turn, increases the amount spent on debt services, leaving consumers with less money to spend elsewhere in the economy. It harms the profitability of dealerships as it increases the cost of their debt (floor plan, mortgage, equipment, and acquisition and operating lines).
Take, for example, a U.S. dealership with a $10 million floor plan. The interest cost on that floor plan has increased by 2 percent in the past 24 months. That amounts to an increased interest expense of $200,000 per year to the dealership.
Higher monthly payments for auto buyers
The rise in short-term interest rates is increasing the cost of monthly payments for auto consumers. This is evident in the data that follow, as monthly payments are hitting all-time highs on both new and used vehicles.
Jessica Caldwell, executive director of industry analysis for Edmunds.com, says this will come as a surprise to many consumers: “For buyers with average credit scores, the rates are higher than a couple of years ago, and that will mean a higher monthly payment.”
High consumer credit levels will likely lead to moderating consumption
One of the unfortunate results of unemployment being at all-time lows and consumer confidence back at near all-time highs is that consumers have gone on a buying spree using credit. The U.S. consumer savings rate recently dipped back near all-time lows (see chart #3), all while consumer credit levels hit all-time highs. Debt allows one to buy today what one must pay for tomorrow. It pulls consumption forward, helping short-term economics and harming long-term consumption. For these reasons, expect consumption to moderate in the near future.
Several record highs could make autos less affordable
The auto industry has hit several record highs, which could make cars less affordable for the average consumer:
- The average auto loan hit a duration of 69 months, while the average used-vehicle loan has a term of just over 64 months, both rising to new record highs.
- The average price paid for a new vehicle hit an all-time high of $35,176, according to Edmonds.com.
- The average new-vehicle loan hit a new record level of $31,099, and the average used-auto loan also hit a record balance of $19,589 (see chart #6).
- The average new-car payment increased to a new all-time high of $515 per month (see chart #7).
Interest rates probably won’t climb much higher
The record-low interest rates in the aftermath of the great financial crisis of 2008 are now behind us, and rates are beginning to increase. The good news is that interest rates probably won’t increase a great deal from current levels because of outstanding global debt, lack of overall inflation, and slow global economic growth.
Interest rates may be approaching their peaks in this cycle, with the 10-year Treasury recently peaking at 2.97 percent. Total global debt has increased from $150 trillion in 2007 (prior to the Great Recession) to $235 trillion today. This level of outstanding debt will prohibit rates from rising much higher, as the increasing costs of servicing this debt will naturally slow the global economy.
As a good stress test, one could use a cost of funds 1 percent higher than today as a worst case scenario in planning financial budgets for 2018 and 2019 — although 0.5 percent is more realistic, based on most credit analysts’ research today.
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