The payment of your car loan can be much too high. This is what is happening – National

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George Iny recalled a woman who wrote that she paid about $550 a month for her new 2018 Toyota Corolla with a seven-year loan.

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“She doesn’t show up as anyone’s statistic, but her household is clearly suffering because she’s overpaying $250 a month for that car,” said Iny, head of the Automobile Protection Agency (APA), a consumer advocacy group.

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Perhaps the most egregious example he has ever seen of an inflated car loan is that of a man who owed nearly $100,000 to a Chevrolet Volt, an electric car.

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β€œWe don’t see people like that every day, but certainly every week.”

Behind the gigantic loans are increasingly long auto loans, early trade-ins and negative equity, a problem long known to insiders but still poorly understood by many consumers, Iny says.

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Negative equity

What is “Negative Equity?” you may wonder.

It means that the market value of anything you bought has fallen below the outstanding balance of the loan you took out to buy it.

In real estate this is known as “being under water” and is relatively rare. Home prices generally go up year after year, so homeowners usually need a housing crisis to find themselves underwater (think what happened in the US after the housing crisis in 2007). Negative home equity can cause a headache as it can force you in a recession to stay in an area where there are no jobs rather than move to where there are more opportunities. You’re stuck because you’d lose money – possibly a lot of money – if you sold the house.

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However, it is different for cars. Unlike houses, vehicles are usually to lose value over time, meaning unless you have a large down payment, you probably owe more on your new car than the vehicle is worth, at least initially.

Vehicles generally lose about a third of their value in the first year of ownership, said Brian Murphy, vice president of data and analytics at Canadian Black Book. The good news is that the rate at which vehicles lose value slows significantly after the first year. Since the pace of your automatic loan repayments remains constant, this means that you will eventually catch up and owe less than your four-wheeler is worth, something known as positive equity.

The smaller your down payment – if any – and the longer your loan term, the more it will cost you to get there.

Henry Gomez/Global News.

Henry Gomez/Global News

The negative equity problem arises when you trade in your vehicle before it is fully paid off, something that is becoming more common among car buyers in Canada.

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Let’s say you bought a $35,000 compact SUV with an eight-year loan and no discount. It can take as many as six years for your vehicle to be worth more than the balance you owe it. For example, if you decided to trade it in after three years, you’d still be $5,800 in the red, according to an example from Canadian Black Book.

Now let’s pretend you have your eyes on a new $40,000 vehicle. To fund that, the lender would fold your old $5,800 balance into the new loan, for a total debt of $45,800.

If you started with a shorter loan but still traded in with negative equity, your lender can keep your debt payments about stable by offering a longer loan, Iny said. While the impact on your cash flow may be minimal, your debt burden is increasing.

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In this way, according to Iny, cars send Canadians into a spiral of debt.

“Ein the end you’re asking for a loan that’s too high compared to the assets you’re buying,” Murphy said.

And that, he added, is when the bank will say “no.”

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The financial crisis, low interest rates and aggressive marketing

Borrowing to buy a car wasn’t as treacherous when the longest car loan you could get was five years, Iny said. The problems started after the financial crisis of 2008, when many car manufacturers started offering a term of up to eight years.

Amid a weak economy and stagnant sales,He felt that if they could keep the payment low enough in a low interest rate environment, they would be able to bring people in,” Iny said.

The strategy worked and the industry recovered after a few years, Iny recalls.

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But the industry soon realized that seven or eight years was too long to see customers again. According to Iny, the solution was to get car owners to trade in their vehicles before the loan term expired, with the outstanding loan balance being included in the new loan.

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To lure customers back in, the industry often resorts to aggressive marketing campaigns, Iny says. Often it is an e-mailed invitation to come and see the new models.

β€œIt’s like wine and cheese β€” like a fancy museum opening atmosphere,” Iny said. β€œBut (they’ll) tell you, ‘Listen, for the same payment we can get you in a new car. Why would you want to keep this old one? You get the Bluetooth, you get the rear camera.”

For many, he said, the offer is “pretty irresistible.”

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But are longer car loans necessarily bad?

If you don’t trade in your vehicle with negative equity, a longer-term loan can be a good deal.

With a zero percent interest rate, a longer loan simply means lower monthly payments, theoretically freeing up money to invest and earn a return on.

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For anything above a zero percent rate, you want to see how much more you would pay in total in interest with a longer loan. But if interest rates are low, it may still be wise to opt for lower benefits.

Those are the “thought out” arguments that Iny says she has heard from financial planners.

In practice, however, he said, many people will not invest a small amount that they could save by a smaller car loan installment. They simply use longer loan terms to keep their payments stable and buy more expensive cars.

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Still, one way to avoid negative equity, even with a longer loan, is to choose a vehicle that holds its value better, Murphy said.

With a Toyota 4Runner, for example, someone with a $54,000 loan for seven years would achieve positive equity after just four years, as the mid-sized SUV depreciates remarkably slowly, he added.

In notes provided to Global News, Murphy compared the 4Runner to an unidentified similar vehicle with a slightly lower price tag, but a worse track record of holding up its value. Someone with a $52,000 loan for seven years for this SUV would have to wait nearly six years to trade it in with no negative equity.

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To help consumers evaluate their negative equity risk, Black Book provides annual rankings of four-year-old models of best-kept values. It also has an online loan equity calculator.

Still, longer loans come with greater risks, even if you choose a vehicle that will depreciate slowly or you don’t plan to trade in early, Murphy warned.

Take car accidents for example.

“If your car is depreciated and your insurance company says your car is worth $20,000, but you still owe $30,000 on it, you can guess whose responsibility the difference might be.”

The longer it takes you to reach positive equity, the greater the risk of being blamed for a vehicle that has been declared a total loss as a result of an accident or theft.

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Some insurance policies offer the option to purchase additional coverage to prevent this, said Anne Marie Thomas of Thomas However, this usually only applies for the first two years after purchase.

Furthermore, there is what is called gap insurance, which will cover all or part of your negative equity for a few more years, Thomas said.

Gap insurance may be worth it, Thomas said. But it’s still an additional cost associated with your decision to buy a vehicle with little or no fix and a longer loan term.

The crux of the problem, Iny says, is that lenders now have car loans worth far more than the market value of the vehicle they need to finance.

While car loans are often slightly more than the price of the vehicle because they can also cover things like taxes and an extended warranty, until about 20 years ago, according to Iny, the maximum a person would borrow was 110 percent of the market value. On a $20,000 car, that would work out to $22,000.

Today Iny said, β€œSome…will allow you to fund up to $30,000 or $31,000.”

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