Taking out a seven-year car loan can create have you drowning in debt later on

Why you need to know about negative equity before buying your car

So, you’re about to buy a car. You’ve picked the one you want and you’re ready to submit an application for a loan. You’ve found a great interest rate and the payments are affordable because you’ll be paying the car off for 84 months.

But hold on a second. Before you buy that car, you should know about an important concept in the automotive world: negative equity.


Negative equity, defined 


At 84 months, you’re looking at taking out a loan for seven years. While this scenario helps you pay less every month — since you’re spreading out your loan over a longer period — it also opens you up to finding yourself with a car that is worth less than your loan. That’s what negative equity is.

According to the Canadian Black Book, in 2018, some 30% of trade-in vehicles in this country had negative equity. That means when someone went to sell them, they got less for the vehicle than what they had left to pay off on their loan. On average, these car owners found themselves $7,051 in the hole.

“This is a very large sum of money, which is why understanding what cars hold value well, negative equity and when during your auto loan you will be in an equity position, is so very important,” said Brad Rome, president of Canadian Black Book.

Negative equity is not a good financial situation to be in. If you’re selling your car and find yourself owing money on it afterward, it’s likely you’re going to roll that debt into your new car loan. And all of a sudden, you’re going to find yourself with a debt load that can get unmanageable pretty quickly.


How do you avoid negative equity?


There are a few ways to avoid this situation.

The easiest way is to try and take a shorter loan if possible. Cars depreciate in value quite quickly — according to Carfax, the value of a vehicle can go down by 20% in the first 12 months alone.

If you’re paying off your loan in a year, well, your car is still worth 80% of what you bought it for, so you’re avoiding the problem entirely.

But not everyone can afford to pay their car off that quickly.

Canadian Black Book also recommends that when buying a car, look at how well the make and model retain value. Earliest this year, the organization released its list of cars that retain their value the best — with Toyota models taking home the most spots.

Understanding how longer loans affect your equity and choosing cars that retain their value can go a long way in helping you avoid a negative equity situation.


Pay attention to interest rates 


Finally, be aware of the interest rate you’re paying. If you’re paying a high interest rate, your costs can add up much faster, even if your loan is shorter. It’s worth sitting down and calculating how much a year you’ll be paying for your car based on the interest rate being offered. For instance, at 10% a year on a $20,000 car loan, you’ll be paying $2,000 in interest annually.

If you plan to pay that for five years, you’re looking at $10,000 in interest. Make sure your car will be worth more than that when the loan term ends. If not, you might want to consider buying a cheaper car.