The Risky Business Of Long-Term Car Loans
Consider this scenario:
Four years ago Farah bought a new car for $30,000.
To keep her payments affordable ($366/month) she financed the purchase over 96 months (8 years) at 3.99%. Her total payment with interest was $35,091.
Farah is a commuter and has driven her car 140,000 km over the last four years.
Now, with her car out of warranty and looming repairs becoming a concern, she has decided to trade it in on a new car costing $35,000.
Because of her 96 month loan, Farah still owes $16,192 on her trade-in.
But because of depreciation and higher than average mileage, Farah’s trade-in is only worth $7,000 meaning she has $9,192 in negative equity ($16,192–$7,000).
So Farah will need to borrow $44,192 ($9,192 + $35,000) to buy the new $35K car.
And according to Ontario’s vehicle sales regulator, OMVIC, Farah’s story is actually very common. “When we ask dealers what percentage of customers with trade-ins have negative equity, most tell us it’s more than 50 percent,” said John Carmichael, OMVIC’s CEO and Registrar.
How does it happen?
Not long ago, four- to five-year car loans were the norm. But today, banks and lenders make it possible for consumers to finance a vehicle over seven to eight, even nine years. That’s a significant length of time for a product that begins depreciating the second it’s driven off the lot. Vehicles that would have been completely unaffordable two decades ago now seem to be financially attainable.
It seems many consumers who agree to extended-term auto financing are focused on short-term gratification rather than potential long-term consequences. “They can buy the car of their dreams, often with no money down, for a monthly, bi-weekly or even weekly payment that seems affordable” explained Carmichael. “Increasingly, these types of consumers are finding themselves in negative equity when it’s time to trade in and purchase another car. That means much higher payments and greater borrowing costs. And while OMVIC may not regulate vehicle financing, we do want consumers to ensure all aspects of their vehicle purchase are informed.”
How negative equity is calculated
In the example above, Farah will borrow nearly $45,000 for a $35,000 vehicle — a vehicle that will begin depreciating as soon as she takes delivery.
Obviously her monthly payments will increase significantly; her borrowing costs will also rise; and if the snowball effect of negative equity is considered (imagine what might happen if Farah does the same thing four years down the road), it’s a borrowing practice that could eventually prove disastrous.
Determine if an Extended-term Loan is Right for You!
Before agreeing to an extended term car-loan consumers should consider:
• How long do you keep vehicles? Do you usually trade them in before paying them off? This often leads to “negative equity.”
• Do you have cash for a down payment or are you financing the entire purchase amount? If you have a down payment, it will lower the monthly payment.
• What would happen if the vehicle was stolen or destroyed and there was negative equity involved? Insurance companies will pay what the vehicle was worth, not what was owed on the purchase loan. Note: some dealers sell insurance that pays off the negative equity in these situations.
• What is the overall cost of a loan? Longer terms may mean lower monthly payments but they also usually mean higher overall costs of borrowing.
For more information and tips about financing a vehicle, visit omvic.ca.