The Dangers of Being a Monthly Payment Junkie
Friday, November 27, 2015
Tis the season for giving…and for spending. Without sounding too cynical, the holidays unleash the consumer in many of us. Sometimes that means ringing up a little higher than wanted balance on the credit card…it’s almost the norm. As consumers we have become accustomed to “immediate gratification,” in part, due to the ready availability of credit. But that doesn’t just apply to seasonal shopping; for car-buyers, vehicles are accessible today (financially) that would have been completely unaffordable two decades ago. Consumers can buy the car of their dreams, with no money down, for a monthly, bi-weekly (or even daily) payment that has somehow become “affordable.” But how? Did cars get cheaper? Are we all significantly wealthier? Or is something else at play?
According to Terry O’Keefe, Director of Communications and Education for OMVIC, Ontario’s vehicle sales regulator, “For many, this is a direct result of historic low interest rates combined with longer repayment terms of 84-96 months.” Traditionally, four to five year car loans were the norm. “Today, it’s common for consumers to finance their vehicle over seven to eight years. That’s a significant length of time for a product that begins depreciating the second you drive it off the lot and it’s not without risk.”
Known as Monthly Payment Junkies, these car-buyers often don’t understand that long-term vehicle financing can set up a cycle of greater and greater debt with subsequent vehicle purchases. Increasingly, consumers are finding themselves “up-side-down” when it’s time to trade-in and purchase another car.
Consumers who are “up-side-down” in a vehicle are said to have “negative equity” – an oxymoron if ever there was one. Both terms simply mean the consumer owes more for a vehicle than it’s worth. Considering how quickly vehicles depreciate, particularly if they are driven more than average distances (e.g. commuters), and how often consumers trade-in; financing a car over 84-96 months commonly means consumers find themselves taking out a loan for a new vehicle that includes additional funds needed to pay off the negative equity owing on their trade-in.
Here’s an example:
Farah buys a car for $30,000 and finances it for 96 months (eight years). Farah’s a commuter who drives 35K kms/year. After four years her car has been driven 140Ks and it’s out of warranty, so she decides it’s time to trade it in on a new vehicle that costs $30,000. Because of depreciation (made worse by the high mileage) Farah’s trade-in is worth $8,000 wholesale – but because of her eight year loan, she still owes $16,500. Farah’s up-side-down to the tune of $8,500. That means to buy her new car she must borrow $38,500 - $30,000 (for the new car) + $8,500 (to pay off her trade’s negative equity).
So, in the example above, Farah now owes nearly $40,000 for a $30,000 vehicle – a vehicle that began depreciating as soon as she took delivery. Obviously this scenario leads to a higher monthly payment and if we consider the snowball effect of negative equity (imagine what happens when Farah goes through the same process four years down the road), it’s a borrowing technique that could eventually prove disastrous for many family budgets.
According to O’Keefe, this scenario is far more common than you might think. “Dealers tell us today that 50-80 per cent of customers with trade-ins have negative equity.”
Negative equity and extended-term vehicle financing has just started to show up on the radar of regulators, dealers, lenders and governments as a potential problem. “We’re not saying car-buyers shouldn’t borrow over an extended term – but they need to consider how much they drive, how long they intend to keep the vehicle and how quickly it might depreciate. They need to be aware of the potential pitfalls of being a monthly payment junkie.”
To learn more about OMVIC, visit www.omvic.ca
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