How to Avoid Getting into Negative Equity
Friday, November 13, 2020
The second post in our ongoing Financial Literacy Series for Financial Literacy Month is about negative equity. We answer what you can do to protect yourself against it, how to identify it, and what comes next.
What is Negative Equity in a Car Loan?
The answer to this question is very succinct: Negative equity means owing more for a car than what it’s worth. How you get into negative equity is more complex.
How to Get into Negative Equity
Let's say you decide to buy a car you really like. If you take out a three-year loan, the monthly payments will be very high. If you take out an extended-term loan lasting between six and nine years, the monthly payments become more affordable.
However, by the time you pay off your loan, your car’s value will depreciate significantly.
If you plan to keep your vehicle for a long time, depreciation may not be a problem. Over time, your needs may change since you first made your purchase. You may want to trade it in for another car before you’ve finished paying off the loan, resulting in heavy additional costs. Let’s take a closer look.
How to Get into Negative Equity: An Example
- Conner buys a car for $30,000 and finances it for eight years.
- Conner drives 35,000 kms per year. After four years, his car has been driven 140 kms. It's out of warranty.
- Conner decides to trade in his current vehicle for another car at $30,000.
- Because of depreciation (made worse by the high mileage) the trade-in is only worth $8,000.
- Thanks to his eight-year loan, Conner still owes $16,500 on his current vehicle.
- Subtracting what Conner owes on his loan from the price he can get from the trade-in is how much negative equity Conner has: $8500.
- If Conner wants to buy the $30,000 car, he must borrow $38,500: $30,000 for the new car and $8,500 to pay off his trade's negative equity
- If Conner decides to buy the new car, he will owe nearly $40,000 for a $30,000 vehicle, which means even higher monthly payments in the future.
Three Questions to Ask Yourself Before Taking on a Long-Term Loan
1. How much do I drive?
Think about how frequently you drive. How long does it take you to get to work? Do you go on road trips? Where do you plan on driving? Greater mileage will depreciate your car faster, hurting its trade-in value. If you take an extended-term loan, it may mean you have to delay your next purchase
2. How long will I keep this vehicle?
Do you plan on keeping the car for your teenager? Is it a fixer-upper? A starter car? If you only plan on driving this vehicle for a short time, it may not be smart to take an extended-term loan.
3. How fast will this car depreciate?
Ask the dealer how fast the car will depreciate. If you drive frequently in a car that depreciates quickly and you plan on keeping the vehicle for only four or five years, you should think very carefully about taking on a long-term loan.
Three Ways to Avoid Getting into Negative Equity
Make a sizeable cash down payment when you buy a vehicle, so your monthly payments will be smaller.
Make extra payments for the loan’s duration to pay off the loan more quickly.
Don't trade in or sell the vehicle until it is paid off.
The Bottom Line
The best way to avoid negative equity is to think long-term. Don't focus on just the car payments you think you can afford. Be honest with yourself about what you need and what you can afford.To learn more, check out our video lesson on negative equity from the OMVIC Academy.
As the regulator of motor vehicle sales in Ontario, OMVIC’s mandate is to maintain a fair and informed marketplace by protecting the rights of consumers, enhancing industry professionalism and ensuring fair, honest and open competition for registered motor vehicle dealers. Visit omvic.ca to learn more about your car-buying rights as well as additional tips for buying a car in Ontario.
For car buying tips, check out the OMVIC Academy. You can view other resources such as multilingual videos and download the OMVIC Car-buying Guide
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