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Understand negative equity and how to avoid it when car shopping

Overview

Published: 06/21/2016

by Arielle Duke

Use FCAC's budget calculator to help plan your next car purchase. You can also visit ItPaysToKnow.gc.ca for more information.

Many car owners face a looming hazard known as “negative equity”. This means they owe more on their vehicle than it is worth when they go to sell it, trade it in or lose it in an accident.

Negative equity is becoming a common issue among consumers who, instead of taking out a car loan with a more traditional term of five years or less, opt for a long-term loan of six to eight years. Typically, however, they still want to trade the car for a new one before the loan is paid off—usually at the four-year mark. After the trade-in, they may want to refinance any debt remaining from that earlier car purchase by adding it to their next vehicle loan.

“Rolling old debt into new debt puts consumers on a debt treadmill where they're paying for cars they're no longer driving. They're increasing their overall debt to buy assets that lose value over time,” says Lucie Tedesco, commissioner of the Financial Consumer Agency of Canada. “If you're increasing your overall debt, there's a good chance the bank will be more reluctant to lend to you, and will charge you higher interest on the loans it does give you.”

Learn how to avoid that predicament by making the right decisions when financing your car purchase.

The longer the term of your car loan, the more time it will take to move from negative to positive equity. For example, under an eight year car loan, you will owe more on the loan than the car is worth, well into the seventh year of the loan.

“Long-term loans offer lower regular payments, but they cost consumers more in the long run,” says Tedesco.

Here are some other ways in which negative equity can put your household finances at risk:

• You're in an accident and your car is a total write-off; the insurance company pays you the market value of a car, which does not match what you still owe on the car.

• Something unexpected happens, such as losing a job, and you must sell your car. You will have to make up the difference between what you get for the car, and the amount you still owe your lender.

How to avoid negative equity?

Tedesco suggests purchasing a car you can reasonably afford and that fits your needs (rather than your pricier wants), choosing the shortest term loan your budget will allow and providing as big a down payment as you can afford.

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