Understand negative equity before you buy a new car

RoadToday_90085HAn increasing number of car buyers are putting their finances at risk by taking on negative equity. This happens when you owe more on your vehicle than it is worth when you go to sell it, trade it in or need to write it off after an accident.

Attracted by lower monthly payments, many are opting for long-term car loans of six to eight years, instead of a more traditional term of five years or less. However, if you opt for this, down the road you’ll probably still want to trade the car for a new one before the long-term loan is paid off — typically around the four-year mark. You may then want to refinance remaining debt from that earlier car purchase by adding it to your next vehicle loan.

“Rolling old debt into new debt puts consumers on a debt treadmill where they’re paying for cars they’re no longer driving. They’re increasing their overall debt to buy assets that lose value over time,” explains Lucie Tedesco, commissioner of the Financial Consumer Agency of Canada. “If you’re increasing your overall debt, there’s a good chance the bank will be more reluctant to lend to you, and will charge you higher interest on the loans it does give you.”

Negative equity can put your household finances at risk when you’re in an accident and your car is a total write-off and the insurance company pays you the market value of a car which does not match what you still owe. You can also be vulnerable if something unexpected happens, such as losing a job, and you must sell your car. In this case, you will need to make up the difference between what you get for the car and the amount you still owe your lender.

You can avoid that predicament by making the right decisions when financing your car purchase. The longer the term of your car loan, the more time it will take to move from negative to positive equity. For example, under an eight-year car loan, you will owe more on the loan than the car is worth, well into the seventh year of the loan.

“Long-term loans offer lower regular payments, but they cost consumers more in the long run,” says Tedesco.

She suggests avoiding negative equity by purchasing a car you can reasonably afford that fits your needs, rather than your pricier wants. You can also choose the shortest-term loan your budget will allow and providing as big a down payment as you can afford.

Check out the FCAC’s budget calculator to help plan your next car purchase online at Canada.ca.