Negative Equity: The Car Loan Trap

By John Hayden

Burdened by auto loans that mysteriously turn into negative equity, thousands of Canadians are trapped in a vicious cycle of debt. These ballooning car loans are generally pumped up by four main factors:

  • affordable down payments;
  • longer payback periods; 
  • early trade-ins; and
  • negative equity roll-overs.

The temptation is always there: who wouldn’t want a brand-new SUV,  with nothing down and a $35,000 price tag paid off through easy monthly instalments? The problem is that paying this amount back (increased by interest and insurance) is scheduled over an eight-year timeframe. 

But after a few years, owners realise that problems are cropping up constantly, repairs are getting expensive, and the resale price has plummeted. By about the fourth year, those attractively low monthly payments have lost their appeal, offset by soaring repair costs, while licensing fees and road taxes must still be paid regularly.

This is when (and why) many Canadians decide to trade in their vehicles, rolling over their unpaid debts. That $35,000 SUV – once shiny but now shabby – might be carrying a debt of $5.000 after four years, which is higher than its market value. That’s negative equity.

What Is Negative Equity?

When the market value of an asset – often a house or an automobile – is lower than the outstanding balance on the loan taken out to buy it, this results in negative equity. For a five-year loan, equity remains negative for about thirty months. However, this negative effect extends through to the sixth year of an eight-year loan.

So it might take anywhere from under two to over six years of payments (and repairs) to bring this amount down to an outstanding balance that is less than the vehicle’s listed price in the Canadian Black Book. But then temptation creeps up again.

Temptations, Temptations

There’s this brand-new model that’s just been launched, packed with innovative features that offer more comfort and greater safety. And it’s ‘only’ $5.000 more than you paid for your outdated SUV – that sounds like a real bargain, right? 

That persuasive salesperson is happy to add the outstanding balance of $5,000 to the new loan: that’s ‘mere’ $45,000 that can be paid off through affordable monthly instalments over a further eight years. But once again, the vehicle value drops sharply during the first few years, when a large percentage of the instalments are paying off interest on the loan (usually at around 3% to 5%  p.a.), rather than the principal amount. 

What Is Positive Equity? 

Smart auto owners know that cars cost more to run each month, as they age. But trading a vehicle after only a few years means increasing the burden of debt, through rolling over the outstanding balance of the loan. 

It’s not until somewhere around the sixth year of an eight-year loan that the market value of the vehicle is higher than the outstanding balance. That’s positive equity.

Mired in Debt

And this is how so many unsuspecting victims get trapped into a never-ending spiral of debt. In fact, the average amount owed on cars in Canada hovers around $20,000. This is a never-ending burden for many families. 

As monthly instalments are generally fixed, car values and outstanding balances move closer together over the years. Once those amounts switch places, and the car is worth more than the remaining amount of the loan, this becomes known as positive equity.

However, smaller (or zero) down payments and longer terms mean slower payback. This means that negative equity lasts longer, with deeper debt, higher fees, and more interest.

Smarter Choices

Vehicles generally lose 20% of their value as they drive out of the showroom, falling another 10% to 15% during their first year on the road. After that, the drop slows down considerably, which is good news for owners repaying auto loans. 

Long term, the smartest option is to pay off loans as quickly as possible, and certainly within five years. Although depending on model, mileage, and maintenance, the trade-in sweet spot is often soon after the halfway mark on a loan: around the fortieth month of a five-year loan, and seventy months for an eight-year loan. 

Safety First 

Final decisions on down payments, instalments, and loan terms are obviously dictated by family finances. However, there’s one factor that must outweigh all others when choosing a car: a ride that’s both safe and reliable is an asset beyond price.

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