If you owe more money on your car or truck than the vehicle is worth, that’s called negative equity. If you’ve not heard of negative equity then you’re not alone, but it’s a problem for many consumers. According to OMVIC, Ontario’s vehicle sales regulator, car dealers regularly report that more than 50 percent of customers with trade-ins have negative equity. So, how does this happen?
For many consumers, negative equity is a direct result of historically low interest rates combined with extended repayment terms. Not long ago, 48- or 60-month car loans were the norm but today, it’s common for buyers to finance their vehicle over 84, 96, or even 108 months.
Financing a car over a longer period reduces the monthly repayment amount to a more affordable level, putting higher-priced vehicles within the reach of more buyers. However, seven or more years is a significant length of time for a product that begins depreciating the second it’s driven off the lot. Many vehicles depreciate quickly, particularly if they are driven more than average distances, for example when commuting. As a result, long finance terms are not without risk.
Let’s take an enthusiastic car buyer, Chris, as an example. Chris likes to swap to a new car every three years. He’s now tired of the one he bought three years ago, but has a seven-year loan, with four more years still to pay off. The dealer has assessed the trade-in value at $10,000, but Chris still owes $15,000. That extra $5,000 doesn’t just disappear. Instead, when he finances his next vehicle for another seven years, the outstanding $5,000 from the first car will be added to the new loan. And if he tries to buy a third vehicle in three years’ time, a second lump of negative equity will be added on top. Soon, Chris will reach a point where he owes so much that the bank may refuse to finance his negative equity any longer.
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Before agreeing to an extended-term loan for a vehicle purchase, consumers should pause to consider how much they drive, how long they intend to keep the vehicle, and how quickly it will depreciate. In short: make sure you’re informed.
“It’s important to understand the risks that are involved in car financing,” says Tim Hines, Director of Consumer Support at OMVIC. “When you’re purchasing a car, don’t just pay attention to the monthly payments, but also to the term of the loan and the overall price of the car. Perhaps you need to purchase a less expensive car in order to get something that fits into your monthly budget, rather than financing the more expensive one for longer. If you plan to trade in the car after five years, then maybe you’re more comfortable with the $25,000 car over five years than the $30,000-one over seven.”
Hines notes that every consumer’s situation is different. For someone who intends to keep a car until the end of its life then a longer-term loan might make sense. Other buyers use a cash deposit to reduce the monthly payments or make extra payments to shorten the repayment time.
Whatever your situation, it’s important to educate yourself and make the right decision because the consequences can be severe if you don’t. In the worst-case scenario, if the vehicle needs a big repair that you can’t afford and is rendered unroadworthy – and therefore worth nothing as a trade-in – you’ll be left with no car and a pile of outstanding debt. Repossession could follow. And the bad news for consumers is that as interest rates rise, banks will be less willing to absorb a chunk of negative equity into a new vehicle loan, putting even more borrowers at risk.
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Dealers are required to expressly state when existing negative equity is part of a new vehicle finance agreement. Further transparency is required under Ontario’s Consumer Protection Act and Motor Vehicle Dealers Act, including clearly stating the annual percentage rate (APR) and total cost of borrowing – the total price you’ll pay for a financed vehicle. Reviewing this information carefully will help you make an informed decision. Remember that if a reputable dealer’s bank refuses to finance a deal based on the negative equity risk, it could be doing you a favour. The dealer down the street who promises to give you credit regardless probably doesn’t have your long-term interests at heart.
“Some people can afford to pay off the negative equity themselves, and that’s great,” says Hines. “But OMVIC receives calls from people who can’t. Most of those car buyers didn’t educate themselves before entering into a completely legal, and legally binding, loan agreement. We urge consumers to do their research upfront and stay out of trouble.”
Visit OMVIC.ca to access free car-buying resources to get you started and sign up for the Consumer Line e-newsletter, and contact OMVIC’s consumer support team at [email protected] or 1-800-943-6002 for answers to all your car buying questions. To see if you are eligible to receive financial assistance from the Compensation Fund, contact OMVIC at 1-800-943-6002 or email [email protected].
This story was created by Content Works, Postmedia’s commercial content division, on behalf of OMVIC.
Keyword: How to avoid the negative equity debt trap when financing your next car