Negative Equity, a Canadian Auto-Industry Epidemic
Consumers buying a vehicle in the 21st century are inundated with choices. Do you want tinted windows? How about that upgraded sound system or navigation? Google Assistant or Apple Carplay? Then there’s appearance protection and all sorts of other options that can add cost. Before you know it, that $25,000 vehicle will cost you well over $30K. Thankfully, car dealerships make it easy to finance (or lease) your new or pre-owned vehicle for a series of reasonable monthly payments over a set term. Now you can get that vehicle with all the bells and whistles without having the cash upfront. Sounds great, right?
It turns out that the reality is a bit less ideal. This is because of something called negative equity. It’s the automotive industry’s Achilles heel and is inadvertently contributing to Canadians having one of the highest debt to income ratios in the world.
What is Negative Equity?
Over the last twenty years, as vehicles became more expensive, many carmakers, lenders, and dealerships have increased the financing terms’ length in an attempt to keep payments relatively unchanged. What was commonly a three-year term previously, has grown to five, six, or even eight years. As the car depreciates in value over the course of the term (the most being in the first year or so), the consumer continues to pay off something that depreciates faster than the buyer can make payments.
Where this gets especially problematic is when consumers decide to upgrade their vehicle partway through the finance term. When you trade-in a vehicle, there is often a difference between how much that car is presently worth and how much is still owed on the loan or lease. This difference is the negative equity.
Example of Negative Equity
Let’s think about it in more concrete terms. Imagine you’re 24 years old, purchasing a new $25,000 vehicle to get you to a job you just started. You can’t afford to buy the vehicle outright, and money is a little tight, so you put very little down and choose to finance it over an 84-month term to keep the payments low.
Life goes on, and by the time you’re 27, you are married with a child on the way. You decide you want to upgrade your vehicle to something with a bit more space for your growing family, but you still have four years left on your financing term. You decide to sell your vehicle. Unfortunately, it already incurred a lot of mileage as your primary work car and is now barely worth $10-11 thousand.
At this point, many consumers owe more than the vehicle is worth, and a common practice is for dealerships to pay off the remainder of your lease or loan and simply roll that outstanding debt into your next vehicle purchase. In other words, they roll negative equity from your previous vehicle into your new lease or loan, and you go further into debt as you start another 84-month term on an even pricier vehicle.
This scenario is not uncommon. Canadian household debt has risen to 176.9%, according to Statistics Canada. In other words, Canadians have $1.77 in debt for every dollar of household disposable income.
Negative equity and the unexpected
Now, where negative equity starts to get really scary is when something unexpected happens that impedes your ability to make your payments. In most cases, these unexpected events are linked to your job or health. For example, you could lose your job, go on disability, or become ill and unable to work. These things happen more often than you may think, especially in today’s climate. And while it might be more practical to return the vehicle to alleviate the monthly payments, along with insurance, fuel, and maintenance costs until you get back on your feet, you would still be responsible for any negative equity.
How to avoid negative equity
None of us plan on these things happening, but it helps to be prepared for when they do. So what can consumers do to avoid the impact of negative equity? Well, there are only two main options: put more money down upfront or invest in high-quality debt protection.
Even if you can’t afford to purchase a vehicle outright, you can significantly shorten the financing terms by putting more money down. Because cars are built to last longer than they were 20 years ago, if you can shorten your term to three or four years and drive your vehicle for seven to eight years, you will get the best value for your vehicle over the shortest period of time.
However, for some Canadians, putting down a lot of money may be unrealistic. In this case, consumers need to strongly consider structuring their leases or loans with a proven, high-quality debt protection product. Ideally, the product you choose should allow you to return your vehicle and cover your monthly payments if something unforeseen happens that prevents you from needing or affording the vehicle.
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