Driven to Spend: How to Avoid Costly Car Loans

According to Statistics Canada, roughly 15.4 million Canadians commute to work, and four out of five of those commuters travel by private vehicle. Essentially that means that, for most Canadians, having a serviceable vehicle is necessary to earn a living. However, the financial cost can quickly become overwhelming when not thought through carefully.

We’re spending more than ever on cars, which might explain why car loans are one of the fastest rising consumer debt areas in Canada right now. In a recent study by my firm, Hoyes, Michalos & Associates Inc., we found that the average insolvent debtor owed almost $11,400 against their financed vehicle, up 12 percent from two years earlier. Even more concerning, these same indebted car owners still owed 89 percent of the value of the car.

The truth is that, unlike a house, a car is not an investment.

It begins to lose value as soon as you drive it off the lot. Depending on how you financed your vehicle, you can quickly find yourself owing much more than your car is worth.

Purchase more car than you can afford, and you may be unable to meet your monthly car loan payments. The shortfall is often handled by using credit cards, payday loans and other unsecured debt to balance your monthly budget, ultimately increasing the risk of bankruptcy.

Here are some factors to consider if you are thinking about financing a new vehicle.

1. Factor in all transportation costs. Spending too much on your car increases your financial risk by making it difficult to keep up with not only your car loan, but also other living expenses. Generally speaking, your transportation costs should not exceed 20 percent of your net income. This includes not only the financing cost of your vehicle (your loan or lease payment), but also gas costs, repairs and maintenance, insurance, even parking costs. Many don’t consider these additional costs when purchasing a new vehicle. Instead, they look at the monthly payment and tend to say, “I can afford that.”
   
2. Keep your loan term as short as possible. Car lenders are quite smart when it comes to convincing buyers they can afford that bigger, newer, more expensive car. In order to reduce the monthly payment, they increase the term of the loan. Terms of six years are now commonplace, and it is not unusual to see car loans offered for eight years or more. While this might lower your monthly payment, allowing you to buy more, the problem arises in that for a significant portion of the term, you owe much more than the car is worth. If you get into an accident or need to trade up, you will owe more money than you can realize on your current car. This leads us to our next risk.
   
3. Avoid car loan rollovers. A relatively new phenomenon in car lending is the loan rollover. Let’s say your current car is worth $12,000. For whatever reason, you decide you need to purchase a new car for $20,000 (perhaps you need a bigger vehicle for your growing family). The problem is, your current car loan might still have an outstanding balance of $14,000. There are lenders who are quite happy to roll the $2,000 shortfall into your new car loan. The problem with this approach is two-fold. First, these loans are very high risk and as a result come with a very high interest rate. Second, you are caught in a cycle of owing more against your vehicle than you will ever be able to repay.

Buying more car than you can afford creates a cash flow problem that is all too often handled with more debt.

My advice is to look beyond the monthly car loan payment. Run some numbers and ask yourself if you can afford all the extra costs. Balance buying a newer car against expected maintenance costs on an older vehicle. Look at the total amount you will be paying and compare what you will owe against what the car will be worth when you expect you may have to purchase your next car. And lastly, buy less. You need a car to get to work—you don’t need a car to impress the neighbours.