Just last month the talk was of interest rates gently rising, heralding a stronger, more resilient economy. So you'd think those new-car dealer gimmicks - the $4,000 rebates and zero-financing deals - would go the way of multiple mortgage refinancings. Well, think again. After several years of hype and hoopla that reached its peak a year ago, auto incentives hit a low point last month, down 7.6 % from June of 2003 - according to Power Information Network (PIN), LLC, an affiliate of market researcher J.D. Power and Associates. What's more, sales dropped nearly 2% compared to a year ago. At General Motors ( GM) and Ford ( F), big incentive boosters, they slowed by at least 15%. Dealers, meanwhile, are sitting on a near record inventory of four million 2004 vehicles. "Consumers have certain expectations when it comes to incentives," said Tom Libby, director of industry analysis at PIN. "When incentives drop, consumers have shown that they're willing to wait until automakers sweeten the deal. We're already seeing automakers increase incentive amounts in July in order to boost sales." With interest rates up only a quarter of a percentage point and June sales at Wal-Mart ( WMT ) and Target ( TGT ) pointing to a softening economy, auto industry observers are predicting incentives will be back in full force this summer. It's all part of the ongoing quest for the right financing formula that will drive vehicles off dealer lots and into the consumer garages. "The auto industry is just a glaring example of how difficult it is to compete in a global arena," said Bob Schnorbus, chief economist for J.D. Power and Associates. "The upside is that it's good for the consumer." Still, if interest rates continue to rise over the next several years, as some economists in the auto industry predict, zero-percent financing will disappear. "We have to wait and see what they come up with," said Schnorbus. But in the short term, with so much 2004 inventory, manufacturers and dealers are "going to have to raise incentives even more."
The only problem is that the industry's short-term financing solutions have a way of boomeranging their way back in three or four years as long-term problems. One reason that cash rebates are so popular is that a growing number of buyers need the money to pay off their trade-in vehicles. The percentage of car buyers who are upsidedown -- that is, who owe more on their trade-in than it's worth -- has increased substantially in the last three years, according to retail data collected by PIN. Since 2001, that figure has risen from 25% of buyers to 38%. Their predicament is the result of manufacturers vying to keep buyers' monthly payments down by lengthening the terms of loans. The average term of a new-vehicle loan is currently 58 months, up nearly 10% from 53 months in 2001. This stretch-out makes it harder for buyers to build up equity, because they are paying less per month on the vehicle, which is a depreciating asset. "Right now automakers are legitimately trying to sustain demand and market share through aggressive manipulation of finance instruments, but the long-term ramifications of these efforts are questionable," said PIN's Libby. General Motors is usually the leader in incentives because it's trying to hold on to its 29% market share, said Schnorbus. The automakers doing the best financially use incentives the least, such as Honda ( HMC), which tends to produce below demand for its vehicles. The big three in this country, GM, Ford and DaimlerChrysler ( DCX), are overproducing, he said. If interest rates continue to rise rise, buyers will probably see two changes in their financing options. Zero financing will disappear in favor of subsidized interest-rate financing. And leasing, which hit its peak in 1998 but fell into disfavor with the rise of incentives, could make a comeback.
"We expect the leasing rate to move up with interest rates," said Paul Taylor of NADA. "It's going to be steady growth for at least three years." In 1998, leased cars made up 36% of the new car market. Last, it had fallen to 19% but is projected to rise to 21% this year. Leasing typically allows consumers to keep their monthly payments low on a car that they might find difficult to afford. And, they know they can't be upsidedown as with a purchase, at the end of the two- or three-year lease period when they can simply turn in the car back to the dealer. For the dealer, a lease counts as a sale. However, when leasing first became popular, leasing companies grossly miscalculated how much consumers should pay for the lease and the value of the residuals, or how much the cars would be worth at the end of the leases. In their efforts to entice consumers into leasing, automakers charged too little for what was essentially the rental of their vehicles. So when consumers returned them, they rarely wanted to buy the auto because the residual value had been priced too high. Dealers were stuck with large quantities of high-quality used cars, and used-car buyers had a bonanza. Schnorbus said he was recently in a dealership that was promoting leases to customers. Consumers are better off if they can afford to buy a car, he said. "It's still a gimmick they can use to help the customer get a lower payment. You never build up any equity." He expects that finance companies will manipulate the residual values and adjust the term of the leases until they hit on monthly loan payments that are desirable to consumers. "You still have to convince the customer that he or she is getting a bargain," he said. "They can fiddle with that residual value. Then that's tomorrow's problem."