He made his first vehicle purchase decision, not based on the price of the car or the cost of borrowing, not based on a thoughtful analysis of how long he planned to keep the car or how fast it would depreciate — particularly because of the high mileage his commute causes, but instead based entirely on how “affordable” the monthly payment seemed thanks to the eight-year term of his car loan.
Here’s Scott’s story…
Four years ago, Scott purchased a car for $30,000 and financed it for 96 months at 3.99 per cent — his payment — a manageable $366 per month.
Since buying, he has put 140,000 kilometres on his car. It’s long out of warranty now, and the gorgeous new models are out with all the latest tech, so Scott has decided to trade the old car in for a new set of wheels, costing $35,000.
Here’s the thing: because of his eight-year loan, Scott still owes $16,192 on his trade-in. But because of depreciation, caused in part because of the above average mileage on the car, his trade-in is only worth $7,000.
In a nutshell, Scott has $9,192 ($16,192-$7,000) of negative equity. That is, he still owes $9,192 more for his car, than its worth.
But Scott is undeterred — he’s still is adamant about buying that new car — so he rolls the negative equity into the loan for the new car. In other words, Scott will have a $44,192 loan for a car that’s worth $35,000 and his monthly payment will shoot up to $538.
LOOK BEYOND THE PAYMENT
Consumers like Scott, who purchase a vehicle based on low payments made possible by long- term loans are sometimes referred to as “monthly payment junkies.” They don’t always consider the overall price of the car, potential additional financing costs, or how long they will be in a negative equity position.
Terry O’Keefe, Director of Communications for Ontario’s vehicle sales regulator, OMVIC, cautions consumers considering an extended-term car loan to understand that negative equity can “snowball” with subsequent vehicle purchases.
“They should also consider what might happen if the car was stolen or written-off in a collision: the insurance company will write a cheque for what the vehicle was worth, not what is owning on the loan.”
This is why some consumers who roll negative equity into a purchase, buy a special type of insurance (sometimes called Gap Insurance) that pays off the negative equity if the vehicle is lost or destroyed, but of course — that coverage comes with its own price tag.
NOT ALL NEGATIVE EQUITY DEALS ARE BAD
Here’s the thing though: there’s nothing illegal about extended-term car loans and in some cases, an extended term loan can be beneficial.
“Extended term car loans can actually be a good idea for some people,” O’Keefe said. “For instance, if you normally keep cars until you drive them to the ground, or you don’t drive high miles and the interest rate was exceptionally attractive (some manufacturers offer 0 per cent), an extend-term loan may make perfect sense.” In determining if an extended-term car loan is a good idea, O’Keefe recommends you ask yourself:
• How long do I normally keep a vehicle? Do I usually trade it in before paying it off?
• What would happen if the vehicle was stolen or destroyed and there was negative equity involved?
• How much do I drive? Will the vehicle reliably last the term of the loan?
• What is the overall cost of the loan? Longer terms may mean lower monthly payments, but they also often mean higher overall costs of borrowing.
In the example above, Scott will owe nearly $45,000 for a $35,000 vehicle — a vehicle that will begin depreciating as soon as he takes delivery. His monthly payment increased as did the amount of interest payable on his loan. It’s a borrowing technique that could eventually spiral — imagine what might happen if Scott does the same thing four years down the road!
To learn more about negative equity and vehicle financing, visit OMVIC.ca