South Africa’s own credit crunch looms

We read recently that the sub-prime lending problem in the US could cost banks and financial institutions as much as $495bn. It is a loss that can largely be attributed to a lack of commonsense lending practices. Home buyers were simply lent more money than they could afford to repay. South African banks escaped exposure to the problem for two reasons. First, they did not buy into international bank’s loan books by way of the sophisticated securitised products, and second because there were no ‘dodgy’ home loan products offered to local consumers.

If only the same could be said for vehicle finance. The combined impact of a slowdown in domestic passenger vehicle sales and devaluation of stock in the second hand market could see South African consumers staring down the barrel of a vehicle credit crunch in five to 10 years time. The finance packages offered to individual consumers to entice them to purchase new vehicles are simply too ‘clever’.

And there are early signs that these deals are putting consumers in a very difficult position. FAnews Online has spoken to a number of people who are struggling to come to terms with the balloon payment on their motor vehicle finance contracts.

Customer carries risk of a balloon payment

The Peugeot website offers a detailed description of the balloon payment: “The balloon is an inflated instalment that falls due at the end of the credit agreement. In terms of the NCA, a balloon payment can now be offered to any customer on an instalment sale or lease agreement without any tax requirements. The balloon amount is traditionally associated with a projected estimate value decided by the length of the finance term, as well as the market sentiment toward the vehicle being financed. The risk associated with a balloon is borne by the customer, meaning the customer is liable for the full balloon value in the final month of the contract…”

Finance houses are using the balloon payment to make monthly instalments more affordable, with balloon payments often as much as 40% of the vehicle’s cost price. So, for example, if you purchase a vehicle with a list price of R300 000 your final payment (which is usually five years in the future) will be R120 000. Your monthly instalment is manageable; but at the end of the term you’re likely to get a nasty shock.

The reason is you have to make the balloon payment to ensure the car becomes yours – but there is no guarantee the car’s value will be equal to the balloon payment. In other words you could be expected to pay R120 000 to complete a deal on a car that is worth R100 000 or less.

Caught in a creative finance ‘catch-22’

The balloon payment is based on the dealer’s best estimate of the retail value of the motor vehicle at the end of the instalment sale agreement. Unfortunately these estimates tend to be on the optimistic side. Consider this ‘example’ to illustrate the problem.

In 2003 Joe Bloggs buys a brand new passenger vehicle with a list price of R250 000. The dealer works out a fantastic repayment option which includes a balloon of 40% of the value of the vehicle. Everyone is happy with the residual because they base their valuations on an annul depreciation of around 15% - meaning the car will be worth R130 000 at the end of the term. After paying his monthly instalments for 5 years, Joe will owe the dealer R100 000 before the car is his.

The reality is that on many makes and models the depreciation has run much higher than the estimated 15%. Joe’s car depreciates at 25% per annum. After five years, instead of the R130 000 resale value he expects on the car, he suddenly finds its value is closer to R80 000. To make matters worse, when he phones around to try and sell the vehicle he discovers that the illustrative retail value is ambitious too. A private sale will fetch R70 000 if he is lucky. His worst fears are realised when the dealer offers him only R60 000 on a trade-in.

A sickening spiral

Joe is short between R30 000 and R40 000. If he sells the vehicle privately he can only hope to get R70 000 for it… And that leaves him owing the finance house R30 000. But Joe needs a new car to survive so he has no choice but to go to the dealer, hat in hand, to make another plan. In doing so, Joe sets the stage for the nasty vehicle finance credit crunch we mentioned in the opening paragraph.

The dealer is only too happy to make an arrangement. He offers Joe a shiny new passenger vehicle at R350 000. And he kindly offers to ‘inflate’ this price a little to compensate for the shortfall on Joe’s old instalment sale contract. When all is said and done, Joe signs a new instalment sale for R380 000, committing himself to another five years of monthly instalments – and of course a whopping R152 000 balloon payment at the end of the term.

The dealer wins on all fronts. He gets another vehicle to boost his second hand stock, he sells a new vehicle and he completes another instalment sale. Joe, on the other hand, is simply deferring his problem. In five years time he will be faced by a similar shortfall when the balloon payment falls due. Except this time, instead of being R30 000 short he could be R60 000 in the hole!

Editor’s thoughts:
The National Credit Act allows for the use of balloon payments on hire purchase agreements; but it does little to establish guidelines for determining an appropriate level for this payment. Vehicle finance houses and car dealers are more concerned with the affordability of the monthly instalment than the final payment – and that is creating serious problems. We would love to hear your instalment sale nightmares and your comment on whether enough is being done to ensure that balloon payments are realistic? Add your comments below, or send them to gareth@fanews.co.za