Avoid the negative equity trap: Smart car financing tips

Buying a car means being able to go where you want, when you want. It’s convenience. A vehicle can give you access to a host of personal and business opportunities that could otherwise slip through your fingers. On average, Canadian drivers replace their cars every 10 years, but many want to sooner! When you decide to buy a more spacious, comfortable or efficient car that falls in line with your finances, you can fall into a trap: negative equity. It’s controversial, and it can lead to excessive debt. But what exactly is negative equity?

Negative equity is frequently misunderstood, though it’s actually quite simple! It’s the difference between the amount you have left to pay on your vehicle and the vehicle’s market value. If your loan balance is higher than the value of your car, you have negative equity, meaning you owe more than your car is currently worth. With that in mind, there’s also the notion of financing with a balloon payment. It’s a term that often comes up when there’s talk of negative equity. It’s essentially putting the unpaid balance of your old loan toward financing a new vehicle. This means that your new loan not only includes the amount you have to pay for your new vehicle, but the debt remaining on your old one as well. This might seem harmless, but building up significant negative equity can be very damaging to your credit and affect your borrowing capacity in the future.

Let’s look at an example:

Three years ago, Serge and Marie-Claude decided to buy a two-seater. They got an auto loan of $20,000. They negotiated a 60-month term at an interest rate of 8.99% and they make monthly payments of $396. With the addition of little Gabriel to the family, they’re back at the dealership to buy a new four-door subcompact SUV. They see a model that has everything they’re looking for. It comes to $35,559, tax included. There’s still $9,500 to pay on their initial loan. The dealer suggests trading in the old car for $6,500 (based on the Canadian Black Book valueⁱ) and add the remaining $3,000 to the loan. This latter amount will be due at the end of loan, in what’s known as a balloon payment. So, their new loan is for $38,559 ($35,559 + $9,500 - $6,500 = $38,559).

Their debt goes from $9,500 to $38,559, not counting interest on the loan. Even though the interest rate of 7.99% is lower than what they had previously, the total amount they owe will be $46,845 once interest is added. To lower the amount of their monthly payments, they decide to repay over the longest period possible, which is 96 months. This brings their monthly payment to $488. As a result, they’ll have to pay back more than what the car is worth, and it will cause them to go further into debt. Their monthly payment, which they’re stuck with for 8 years, will go from $396 to $488.

It’s important to note that the value of the car will go down as soon as it’s out of the dealer’s lot, and that depreciation will continue year after year. Since their loan payments are fixed, they might find themselves with negative equity for a long time.

A balloon payment can help you get the vehicle you want despite your existing debt. It seems simple enough, but beware: it’s called a balloon payment for a reason. A car loses value each year, but your debt doesn’t go down accordingly.

Serge and Marie-Claude need to renovate their basement after some water damage. To do so, they’ll need to sell their SUV. However, it’s depreciated, and has a market value lower than its original value, and they’ll likely still have debt after the sale. And then they won’t even have a vehicle!

On the way home from his night shift at the factory, Serge gets into an accident in the SUV. Since his car insurance policy doesn’t include Replacement Cost coverage, the insurance company only gave them a cheque for $17,300, which was the value of the vehicle at the time of the accident. This means that they end up with a vehicle that has a lower value, despite the fact that they still have almost $30,000 left to pay on their totalled SUV. Essentially, they ended up buying a standard car for the price of an SUV because of their negative equity and the accident, even though the latter wasn’t Serge’s fault.

After some time, the couple finds that there isn’t enough space in the SUV to store Serge’s tools and hockey equipment and all of the things for Gabriel. They want a more spacious, and hence more expensive, vehicle. Since they already have negative equity, they need to finance their existing debt in addition to the loan they needed to purchase the new SUV. This means they’ll have even more debt, which will limit their access to credit in the future.

Financing with negative equity is controversial and condemned by many institutions, but it’s legal. The vehicle you make payments on belongs to the financial institution until it’s paid in full. However, dealers who offer to finance your debt on a new loan must inform you of the implications in accordance with section 148.1 of the Consumer Protection Act. If you find yourself with negative equity, it doesn’t necessarily spell disaster. You might not have any other options. Refinancing an auto loan with a second, larger loan isn’t a decision to take lightly. That’s why you should think about the long-term impact and how it could affect other purchases you may want or need to make.

How can you avoid taking on negative equity?

• Make sure you stick to your budget. If your monthly payment is set at $475, make sure you respect the limit. For example, if you finance a $24,000 vehicle over 5 years, it won’t only help you stick to your budget, but it can also give you additional room to save up for unexpected expenses.
• Make additional payments when you’re able to. This will allow you to shorten your loan term and reduce the amount of interest you’ll have to pay.
• Be patient. Despite the depreciation, any vehicle will eventually reach a point where its residual value is higher than the remaining loan balance. That’s when it might be worth trading in your car for a new one.
• Sell your vehicle on your own. You’ll often get a better price than at a dealership, which has to offer a warranty and make a profit.

ⁱ Automotive Data with Canadian Black Book | Powering The Auto Industry With Data