Are car subscriptions better than vehicle financing?

Tinashe Ruzane

IN 2020, the average price of a new car in South Africa was R321 715, way beyond the budget of the average wage earner without the use of vehicle finance.

Driven by strong social pressure to own a vehicle, South Africans can spend as much as half of their monthly salaries on the cost of a new vehicle, forking out an estimated R6 000 a month to finance the average new car over six years.

The total cost of car ownership is, of course, much higher than this figure suggests – once maintenance, insurance and fuel are factored in, the average new car owner carries a total cost of more than R8 000 a month, escalating yearly.

As more and more consumers buckle under the pressure of debt, new business models are cropping up that are poised to disrupt conventional car buying. The car subscription model is one of them.

The negative equity trap

Few understand the complexity of vehicle financing or how this multibillion-rand product manages to remain the dominant driver of car sales in markets such as South Africa. To understand the shortcomings of car loans, we must understand how they work and the role they play in the market.

One of the core strategies of the auto loan industry is to lock consumers into longer contracts to transfer more risk to the customer and maintain the perception of affordability through lower monthly repayments. It has become increasingly common for South Africans to take six-year car loans to keep up with rising car prices – despite the fact that most new car buyers never keep a car for much longer than three years.

Although longer repayment terms seem appealing at face value, they saddle consumers with negative equity for longer. Negative equity is the state one enters when the amount owed to the bank exceeds the value of the car, making it impossible to part ways with one’s car without a large additional payment to the bank.

Higher interest rates, longer loan terms and bigger balloon payments are all factors that can expand negative equity, keeping most car buyers trapped with a perennial debt burden.

The car sales process makes it worse

The negative equity trap is exacerbated by the information asymmetry embedded in the car-buying process. The typical car buyer knows far less than the dealer about how the car will depreciate, what the optimal financing structure for the car should be, and what it will cost to keep the car operational during the loan term.

Consumers carry all the risks, while the industry benefits from unrestrained promotion of precarious loan terms, alongside the sale of the car. Car dealers are well incentivised to perpetuate this distribution model that is heavily reliant on the sale of car loans.

Once consumers are ready to commit to buying a car, the common practice is to progress the customer to the “finance and insurance” leg of the transaction, where the dealers earn most of their money selling the car loans and other insurance products. It’s a no-win situation for many car buyers, who often submit to egregious loan terms that can overburden them with large balloon payment obligations.

Ill-prepared consumers buying cars in this way should expect to be driven into an unfavourable financial position, particularly if they don’t plan to keep the car for more than six years. The standard loan terms used in car ads today (usually hidden in the fine print) clearly validate the industry-wide strategy to lure consumers into financing over six years with a 35% or higher balloon payment.

Winds of change

The inflection point for the auto industry is upon us. Global online auto retailers such as Carvana are upending the distribution model for used cars, while brands such as Tesla have managed to eliminate the need for a traditional dealer distribution model altogether, selling all its vehicles online only.

Similar to how companies such as Netflix disrupted the distribution models of walk-in video stores and DVD rentals, new business models in the auto industry force a transition away from prioritising unit sales to maximising the consumer experience.

Thanks to the rise of e-commerce and a growing affinity for service-driven business models over product-driven models, “buying” is no longer the unchallenged default. Increasingly, it is access, rather than ownership, that drives consumer spending. A growing number of consumers around the world are turning to car subscription services to acquire vehicle access and enhance the flexibility of their lifestyles.

Car subscription services are a hybrid between short-term rentals and long-term leases, making it possible for customers to subscribe to temporary car “ownership” without any long-term commitment and a convenient all-inclusive monthly fee. On car subscription marketplaces, consumers have access to a range of vehicles, earning reward points for good driving behaviour. The car subscription model’s strength is its incredible flexibility and diversity of vehicle brands, with a host of vehicle providers able to launch all-inclusive subscription offers easily, giving it broad appeal.

Vehicle financing remains a good product for those looking to keep the same car for six or more years. For everyone else, car subscriptions offer a superior hassle-free experience. They align perfectly with the demand for flexibility, simplicity and ease of access, offering everything a typical car buyer wants without the sense of encumbrance common to ownership via debt or as a result of carrying the risk of theft, damage and maintenance. They are fast becoming a permanent category of automotive retail, poised to grow and hold their own as more consumers look to move away from long-held vehicle financing norms.

Tinashe Ruzane is the co-founder and chief executive of FlexClub.

*The views expressed here are not necessarily those of IOL or of title sites.

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