How Long-Term Car Loans are Causing Bankruptcy - LawNow Magazine

How Long-Term Car Loans are Causing Bankruptcy

The days of buying a vehicle with cash are long behind us. Car loans and leases are now commonplace. It’s feasible to have a 3-5 year car loan, pay it off, then own the car. It’s a reasonable timeframe for the average consumer and also ensures that an affordable loan is borrowed. However, problems arise when car loans exceed 5 years.

These days, an increasingly popular method of financing a car is to sign a lengthier term loan, including some that are even 8 years long. In fact, more than half of all car buyers in Canada are taking out loans of 84 months or longer.  But while a longer repayment period makes monthly payments smaller for a more expensive car, you may want to reconsider risking your financial health to purchase a depreciating asset.

What are long-term car loans?

Provincial laws provide an exemption from seizure for a motor vehicle, under certain conditions, generally if the vehicle has a value below the provincial limit. For example, in Ontario you can keep a vehicle worth up to $6,600.

Long term car loans are loans that exceed 60-month terms. In other words, loans that are 6 to 8 years in length. The short-term benefit to a longer repayment schedule is it can more easily help you manage the costs of a new car you would otherwise not be able to afford.

When you do this, however, you are taking some big risks:

Overpaying for a car

Smaller monthly payments can be attractive. But, what you may not realize is that by accepting a longer-term loan, you are paying for much more than the value of the car through interest charges.

Let’s say for example you buy a car that costs $35,000. The interest rate on your loan is 5%. Your term of the loan is 36 months (3 years). If you borrow for 3 years, you are paying $37,763.33 for the car because you made $2,763.33 in interest payments. Because it’s a 3-year loan, your monthly payments on it would be approximately $1,048 a month.

However, if that monthly payment is too high and you opted for a longer repayment period of 72 months instead (6 years) at 5% interest on a loan of $35,000, you would pay more than double in interest charges. Over the 6-year period, the car would cost you $40,584.43 because you made $5,584.43 in interest payments. Your monthly payments on this extended loan, however, would only be $563.67.

While this seems more affordable on the surface, it’s actually costing you much more to own that car. Instead, you could purchase a vehicle that falls more within your monthly spending limit, without an extended loan.

In addition to high interest charges, the risk of longer-term car loans is ending up with negative equity. Remember that a car is a depreciating asset. It loses some of its value the moment it’s driven off the dealership lot. So, why extend your payment period for an asset that loses value with each year?

Having negative equity

Negative equity means owing more on a car than the car is worth. While this is not uncommon, there is a much higher risk of financial trouble on extended loans.

Personal bankruptcy law in Canada is governed primarily by the Bankruptcy & Insolvency Act (BIA). In addition to Canadian bankruptcy law, there are provincial laws that create bankruptcy exemption limits. These allow you to keep certain assets like your basic household furniture, clothing, tools necessary to your work, etc.

If your car has declined in value to $20,000, but your loan balance is $27,000, by purchasing a new car, you will have to rollover the remaining $7,000 to your new car, which can make the new purchase much more expensive. This can lead to serious debt trouble when you have a car loan that’s a lot longer than 3 to 5 years. Unless you have taken very good care of your vehicle and have had no accidents, chances are that in 5 to 7 years, you may need a new car or just want one that’s more efficient.

If in 5 years your car is no longer working as well as it used to; has lost significant value and you still owe over $10,000 on the loan, it can be very expensive to purchase a new car when you rollover the remainder of what you owe. Doing this frequently and not paying off your auto loan in full can lead to serious debt problems.

Car loans and insolvency

From the Hoyes Michalos bankruptcy study we know that the average debtor with a car who files insolvency is likely to owe more than the realizable value of his vehicle, which is an added burden when the time comes to renew the loan. In 2017, over one-third (34%) of all financed vehicles had a negative car equity, up from 33% in 2015 and 31% in 2013.

Car loan rollovers have become an increasing concern, especially for Canadians with poor credit, as they are often forced financially to roll the balance owing on their old car into their new car loan. For vehicles with a shortfall, the average car loan was underwater in 2015-2016 by $9,385, up from $7,045 in 2011-2012.

If you have a significant amount of unsecured debt and are considering your debt relief options, it’s important to know that you can keep your car after filing for insolvency. Personal bankruptcy law in Canada is governed primarily by the Bankruptcy & Insolvency Act (BIA). In addition to Canadian bankruptcy law, there are provincial laws that create bankruptcy exemption limits. These allow you to keep certain assets like your basic household furniture, clothing, tools necessary to your work, etc.

Remember that a car is a depreciating asset. It loses some of its value the moment it’s driven off the dealership lot. So, why extend your payment period for an asset that loses value with each year?

Provincial laws provide an exemption from seizure for a motor vehicle, under certain conditions, generally if the vehicle has a value below the provincial limit. For example, in Ontario you can keep a vehicle worth up to $6,600.

Vehicles financed either through a lease or bank loan are also treated differently. Secured debt, like a car loan or lease, is not included in a bankruptcy or proposal. In most cases, debtors do not have enough equity in the vehicle to surpass provincial exemption limits.  As long as you can keep up with your monthly payments, you can continue to keep your financed vehicle even if you file insolvency.

However, what if your car is only worth $13,000 for a trade-in or resale, does it make sense to pay off the remaining $19,000 that you owe on the loan? It might actually be better for you financially to return your car to the dealership and include the shortfall amount into a bankruptcy or consumer proposal.

How to avoid car loan debt

To avoid risks such as negative equity and overpaying on interest charges, I’d recommend looking beyond just the monthly payments. While longer-term car loans often appear more affordable, they are not in the long-run.

When purchasing a new car:

  • Keep your loan period as short as possible, ideally between 3 to 5 years.
  • Save as big a down payment as you can for the car
  • Purchase the least expensive vehicle that meets your needs.

If you get into financial trouble, consider speaking to a Licensed Insolvency Trustee who will take the time to review your financial situation and provide you with a customized solution to help you achieve debt relief.

Authors:

J. Doug Hoyes
J. Doug Hoyes
J. Douglas Hoyes, B.A., C.A., CPA, CIRP is a Licensed Insolvency Trustee and co-founder of Hoyes, Michalos & Associates Inc. in Ontario, Canada. He is also the host of Debt Free in 30, a weekly podcast about how to handle money and debt.
 


A Publication of CPLEA