Car loan

A car loan is a form of borrowing offered by dealerships and other lenders to finance the purchase of new or used vehicles. Car loans are a form of consumer debt. Since vehicles are depreciating assets (they rapidly lose value over time), car loans are generally considered a form of "bad debt". Yet car loans are increasingly popular, and being offered over increasingly long terms.

This article starts by explaining why these loans are popular, then outlines a number of issues with car loans, including negative equity. It concludes with ways to reduce the risks associated with such loans.

Why car loans are popular

Many cities in North America are designed for cars, and public transit isn’t what it could be. In rural areas, there may be no alternatives to cars. Consequently, automobiles are "the nonfinancial asset most widely held by consumers in Canada".

New cars are expensive, and there is a temptation to keep up with neighbors, work colleagues and friends, who might all drive nice looking cars. Paying cash for such an expensive item can seem difficult, especially for younger people. Car loans make people think of big purchases in terms of monthly payments, rather than a lump sum. If you don’t actually do the math to figure out the total cost, paying $X per month over some period might seem more affordable than coming up with $Y right now.

According to Statistics Canada’s Survey of Financial Security, 30% of Canadian households had a vehicle loan in 2019, up from 21% twenty years earlier. The median amount owed was $18,000 in 2019, up from $13,200 in 1999. In fact most Canadians borrow money when they purchase a vehicle. The Financial Consumer Agency of Canada (FCAC) noted that in the years leading up to 2016, the expansion of consumer debt in auto loans had "outpaced that of all other forms of household credit, including mortgages".

Types of lenders

There are three types of lenders from which you can get financing from, at the car dealership:

• the financing divisions of the car manufacturers
• financial institutions such as banks or credit unions
• independent finance companies specializing in vehicle loans

When a car dealer acts as an intermediary between the lender and the consumer, the dealer gets a commission. When multiple loans offers are available (from different lenders), the dealer may take the commission into account when choosing which offer to present to the consumer. Ask to be shown different offers.

Additionally, you may arrange your own financing before you visit the dealer, using a car loan you found yourself, or perhaps a line of credit.

Problems with car loans

Car loans can constitute suboptimal choices or even traps, from a financial point of view.

Paying interest for a depreciating asset

First, car loans involve paying interest to buy a rapidly depreciating asset, hence their reputation as "bad debt". With house mortgage payments, you are also paying interest but expecting the house value to remain stable or increase. With a car loan, the interest rate can be higher than a mortgage, and more importantly, the car starts to lose value the minute you drive it off the dealership. On average, new cars loose 30% of their value during the first year. Some cars lose 50% of their value or more in the first three years.

Paying thousands of dollars of interest on a depreciating asset will not help you increase your net worth.

You may see a zero percent interest loan advertised, but is the interest rate actually zero? Ask the dealership if there is a different total price if you pay cash. If the "cash" price is less, the loan is not actually free.

Buying a car you can’t really afford

Second, financing the car purchase might lead you to buy a more expensive vehicle that you would otherwise have. This is especially the case with long loans which provide "affordable" monthly payments. The dealership will be happy, but should you be?

If you were paying cash, it might "hurt" more psychologically, and you might decide to get a less expensive vehicle. The latter can also be cheaper to maintain and insure. Having to pay cash might even lead you to choose a reliable second-hand vehicle, potentially yielding major savings (since someone else will pay for the initial rapid depreciation). See the Canadian Automobile Association's Driving Cost Calculator to compare different new and used car options in terms of the total cost of ownership, including depreciation, fuel, maintenance, licensing and registration, insurance, and any car payments.

Remember, the primary goal of owing a car is to get from point A to point B. Think about your other financial goals and your debt load before you sign anything.

Extended term loans

Extended term loans are those lasting 6 years (72 months) or more. These are increasingly popular because they have lower monthly payments than shorter conventional loans. In 2015, these longer loans represented "more than 70 percent of new auto loan bookings". In 2019, over half of car loans lasted 7 years or more. Problems with extended term loans include:

• The total amount of interest paid will be higher than for a conventional loan
• There may be a temptation to get a more expensive car, made apparently affordable (in terms of monthly payment) by the longer loan
• Negative equity (see next section)

Even the chief executive officer of Ford Canada is worried about the popularity of loans with extended terms.

Negative equity

With car loans in general, but extended term loans in particular, you can owe more than what the car is worth. This is known as negative equity or "being underwater". Negative equity typically peaks during the second year, after heavy depreciation. If you actually keep your car until the end of the loan, the issue disappears, but many Canadians like to trade in their car for a new one every 4-5 years, even if their loan was longer and they have not finished paying it back.

So if you sell your car before the end of the loan, especially during the first few years, you still owe something to the lender and you have no car left. Take the example of a car that ended up costing $35 000 including taxes and fees, financed at 4% interest. If you pay that back over 8 years, you will have significant negative equity over most of the life of the loan, peaking in the $10 000 range:

Whereas with a more conventional 5 year loan, the negative equity situation lasts fewer years, and the amount is less:

Trading in a car with negative equity happened to 30% of customers in 2015, for an average of around $6,700 of negative equity. The 30% proportion still held in 2019. Although adding the amount still owed to a new loan is illegal is some Canadian provinces, dealers tend to find ways to do it anyway.

This phenomenon is also known as the "car loan merry-go-round" and the "auto-debt treadmill".

Why would you trade in a car with negative equity? The marketing can be aggressive:

But (they’ll) tell you, ‘Listen, for the same payment, we could get you into a new car. Why would you want to keep this old one? You get the Bluetooth, you’ll get the backup camera’.

According to the FCAC, "there are limits on the number of times consumers can roll over negative positions before they begin exceeding lenders’ risk threshold … it is much more difficult to roll over negative equity positions a second time, and almost impossible to roll them over a third time". Which means you end up with a higher debt load, and you ultimately can’t finance your next vehicle, at least not at the interest rates offered to ‘prime’ customers.

Even if you intend to keep your vehicle for the life of the loan, there are risks with negative equity. If you are involved in a road accident and the car is a total loss (or the car is stolen), the insurance company will give you what it thinks the car was worth (the replacement value), not what you owe on it. So you will have to come up with the amount of the negative equity to pay back the loan, or roll it over to a new loan. The longer you have negative equity exposure, the greater the risk of this type of situation happening. Similarly, what if you lose your job and can’t make car payments while in negative equity territory?

Non-prime lending

Non-prime loans are offered to less credit-worthy borrowers, but carry higher interest rates. With such higher rates, and an extended term, customers may end up paying the vehicle twice: once in principal and once in interest.

Reducing the risks

If contemplating the purchase of a luxury car, especially on credit, have a look at the US study called Luxury car owners are not happier than frugal car owners. That study concludes that "frugal cars", in the $5k-35k range, are better purchases from a happiness point of view: "if anything people consuming luxury cars are less happy than those consuming good frugal cars controlling for income and other happiness predictors".

The least expensive way to purchase a vehicle is typically to save up for it, every month or every year, perhaps in a high-interest savings account. While you are saving for your next vehicle, you are earning interest from the bank, rather than paying it. You can then be one of these people who proudly pay cash for their next car.

If you can’t afford a new vehicle that way, consider a reliable second-hand model instead. You can avoid most of the depreciation by buying a ~5 year old vehicle from the highest quality brands, or a ~4 year old one from the less sought-after brands.

If you decide to borrow anyway, the FCAC offers the following advice to reduce the risks:

• buy a car that you can reasonably afford
• choose the shortest term loan you can afford
• pay some money up front when you buy the car
• avoid trading in your car if the amount you owe on your loan is more than your car is worth

See also

• Auto insurance

External links

• Financial Consumer Agency of Canada, Financing a car
• Financial Consumer Agency of Canada, Shopping around for auto-financing
• CBC News, Long-term loans: The fuel that's powering Canadian car sales, October 2018
• LaPresse, La mécanique malsaine du financement auto, June 2016