There’s a growing trend amongst some consumers that may have unexpected financial consequences ‘down the road’. Known as Monthly Payment Junkies, these consumers ignore the potential pitfalls of financing a vehicle over an extended term such as 84-96 months and make their car-purchase decision based solely on a low monthly payment.
Consumers who are “up-side-down” in a vehicle are said to have “negative equity”. Both of these terms simply mean the consumer owes more for the vehicle than it’s worth.
When we consider how quickly vehicles depreciate, particularly for commuters who pile on a lot of kilometres each year, and how often consumers trade-in, financing a car over 96 months commonly means consumers need to borrow much greater sums when they trade-in a vehicle that still has years owing on it. These consumers find themselves taking out a loan for a new vehicle that also includes extra money needed to pay off the negative equity owing on their trade-in.
Understanding Negative Equity
Consider the following example:
Bob buys car ‘X’ for $30,000 and finances it for 96 months (8 years). Bob’s a commuter who drives 35K kms/year. After four years car ‘X’ has 140Ks so Bob decides it’s time to trade it in. He wants to purchase a new vehicle (car ‘Y’) that costs $30,000. Because of depreciation (made worse by the high mileage) Bob’s trade-in is now only worth $7,000 wholesale – but because of the 8 year loan, he still owes $16,000. Bob’s up-side-down to the tune of $9,000. Therefore, to finance car ‘Y’, Bob must borrow $39,000 - $30,000 (new car) + $9,000 (negative equity).
In the example above, ‘Bob’ now owes nearly $40,000 on a $30,000 vehicle, a vehicle that began depreciating as soon as he took delivery. Obviously this scenario leads to higher monthly payments and when one considers the snowball effect of negative equity (imagine what happens when Bob does the same thing four years later), and the risk of higher interest rates looming, the trend of 84-96 month vehicle loans could prove disastrous to many family budgets.
Consider the following tips on arranging auto financing:
- Consider the term and interest rate.
- Ask questions.
- How long do you keep vehicles?
- Do you usually trade them in before paying them off?
- Do you have cash for a down-payment or are you financing the entire purchase amount?
- What would happen if the vehicle was stolen or destroyed and there was negative equity involved? Remember: Insurance companies will pay what the vehicle was worth, not what was owed on the purchase loan.
- Determine the overall cost of a loan.
- Longer terms may mean lower monthly payments but they also mean higher overall costs of borrowing.
Dealers can often arrange exceptional financing for their customers. It should be noted however that most dealers have access to a number of different lenders. Most lenders pay a fee to the dealer for arranging the financing. Consumers should ensure they are getting the finance terms they want and can afford.
Just as consumers educate themselves about the vehicles they intend to buy, they should also inform themselves of the products/services available to pay for those vehicles.
Before visiting the dealership, contact their bank/financial institution and inquire about the terms and interest rates they can offer (they do vary between lenders). This allows consumers to comparison shop with the financing available at the dealership.
At most dealerships the price of vehicles is negotiable; often, so are the finance terms (i.e. interest rate). Don’t fall into the trap of only negotiating a monthly payment; negotiate the all-in purchase price and the interest rate and term.
Check Credit Worthiness
The term and rates available will be based, in part, on the vehicle purchased and the buyer’s employment history and credit-worthiness (credit score). Before applying for any large loan, consumers may want to inquire about their credit score by contacting a credit bureau agency.
Two of the most commonly-used are:
Remember: Be an informed consumer. Understand the possible risks associated with long-term auto financing and carefully review any vehicle purchase agreement and finance agreement before signing.
For more information on the dangers of monthly payment junkie, read the December issue of the Consumer Line.