To make the right decision when financing a motor vehicle, consumers must take into account several factors. In most cases, consumers will use their personal line of credit or arrange for financing at their own bank or credit union, however many opt to have the dealer arrange financing for their purchase.
When a consumer is trying to decide which finance option is best for them, they should remember to look at the big picture – the monthly payments, the selling price of the car, and the cost of borrowing – to know whether the deal is in their best interests. It’s not necessarily about getting a “good deal” or a “bad deal”, rather a consumer should ensure they are satisfied with all the terms of the purchase and confident they’re making an informed financial decision.
Some consumers tend to obtain vehicles using long-term loans in order to make low monthly payments. These consumers set their sights on having a low monthly payment rather than focusing on the total amount to be financed. In many cases, car buyers are unaware that long-term vehicle financing can lead to spiraling debt with each subsequent purchase. Increasingly, consumers find themselves “upside-down” with negative equity when it’s time to trade in and purchase another car.
What is Negative Equity
Negative equity is when a consumer owes more on a vehicle than it is currently worth. The depreciation rate of many vehicles is extremely high, especially if they have a high mileage. So, financing a car for 84-96 months typically requires consumers to borrow additional funds for the purchase of a new vehicle in order to pay off their negative equity.
Here’s an example:
Julie bought a car for $30,000 4 years ago.
She financed it for $366/month over 8 years (96 months) at 3.99%.
Julie drove her car 140,000 kms over the last 4 years: now she wants to trade it in on a new car costing $35,000.
Because of her 8-year loan, Julie still owes $16,213 on her trade-in.
But because of depreciation and higher than average mileage, her trade-in is only worth $7,000 wholesale. Julie has $9,213 ($16,213 - $7,000) of negative equity.
So Julie will need to borrow $44,213 ($9,213 + $35,000) to buy the new car. Her monthly payment will increase to $538.
In the above example, Julie now owes nearly $45,000 for a $35,000 vehicle—a vehicle that will begin depreciating as soon as she takes delivery.
Noticeably, this scenario leads to a higher monthly payment (and increased borrowing costs), and if the snowball effect of negative equity is considered, it’s a borrowing technique that could eventually prove disastrous.
Understanding how financing agreements will affect a consumer’s finances day-to-day, month-to-month and year-over-year will help provide a solid understanding of different needs and wants.
A Common Problem
Consumers who are considering extended-term car loans should consider their driving habits, their intended use of the vehicle, and how quickly the vehicle depreciates before they sign up for an extended-term loan. For more information regarding long-term auto financing and negative equity, visit omvic.ca.
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