New Vehicle Financing: Avoiding the Negative Equity Trap

Consumer financing for new vehicles can be a tricky, touchy subject.

Around the time of the 2008 financial crisis, extended-term automotive loans started hitting the market. These are the types of loans that stretch repayments over six, seven, or even eight years as opposed to the five-year maximum that was long the industry standard.

These types of loans allow buyers to choose cars they otherwise couldn’t afford because the longer term creates lower monthly payments. Someone who could only afford the payments on a compact car over a five-year term might be able to take out a loan with a seven-year term with similar monthly payments and get into the compact SUV they prefer, for example.

However, the risk with these types of loans is a situation called negative equity, where a consumer needs to sell the car before the term is up – a family’s needs change, the buyer’s financial situation changes, they want the latest technology, what have you – but there’s more owing on the loan than what the car is worth when it’s sold.

This puts the buyer in the uncomfortable situation of either having to live with the car for longer than they want to or having to roll the difference in price into their next loan, giving themselves an even deeper hole to dig out from.

Interest rates vs financing terms

Negative equity, and the fact that car companies haven’t done a very good job of informing consumers about it, is something that not a lot of people want to talk about. But Ted Lancaster, vice president and chief operating officer of Kia Canada, sat down with us recently to do just that.

“I’m a big proponent of transparency,” Lancaster said. “We don’t always win in this industry. It’s tough. Trustworthiness in sales in automotive is not ranked as high as we would like to see. I think we’re far better now than we were 15, 20 years ago, but still the perception is situations like this.

“I hear this quite a bit from friends of family or friends of friends where they say, ‘The salesperson told me to finance for seven years and I’d be able to get into a bigger vehicle, and now I’m looking to trade it in and I’m having a tough time.’ And that’s the last thing I want to hear.”

The good news, Lancaster said, is that with interest rates beginning to edge upward, the resulting financing environment is leaning back toward shorter terms that should help consumers make choices that are more within their means.

“Rates going up is actually not a terrible thing because we can still offer zero percent interest but we’re having to shorten the terms just from a cost perspective,” Lancaster said. “For every quarter point that the rate goes up, it’s an impact of anywhere from $500 to $1,000 over the course of the term to the car companies. So, what you’re seeing is if there is zero percent in the marketplace, it’s not zero percent for 84 months anymore. We’re seeing zero percent for 60 months, or zero percent for 72 months. So, customers can still get that, but the term is shortened.”

Benefits to long-term financing?

Lancaster pointed out that extended-term financing could very well be the right financing product for certain types of buyers and that every individual should assess their situation independently.

“Yes, we still offer longer-term financing because our dealers are asking for it,” he said. “And there are some consumers that do want that because they plan on paying it off and owning the car for 10, 15 years. I think if that’s your plan, take the least expensive payment you possibly can.

“But if your plan is to stay up with technology and rotate through vehicles as much as possible, I would encourage consumers to get into a vehicle that fits the 60-month time period. I say that for our brand particularly because our warranties are five years, 100,000 kilometres, so it fits nicely with the warranty.”

The final question remaining for consumers is whether to finance directly with the automaker or to go to a major bank. Lancaster named several reasons why he sees automaker financing as the better option.

“Your own independent bank is going to offer you what the core rate is,” he said. “We buy down from that core rate, so if the bank says it’s a 3.9 percent rate, we’re buying down and offering 0.9 percent. So, dealing with OEM financing is typically a better deal than if they go to their own bank unless they have a credit line or something like that.

“That gives us access to that database information as well, so it’s easier to keep track of the consumer. If they move, if something changes, we can easily be updated because consumers are pretty good about notifying who they owe money to. If they’re with a bank, when they relocate the bank will get that information, but it doesn’t necessarily mean that we’re going to get it. So, if there’s a recall or a needed inspection, something of that nature, it’s tough sometimes for us to get the data.”

From the banks’ perspective

For a counterargument, autoTRADER.ca contacted all five of Canada’s major banks for comment. Three of them – RBC, TD Canada Trust, and Scotiabank – declined the opportunity, and BMO did not respond to requests.

Fabien Adam, director of auto finance and personal banking products for CIBC, pointed out an online calculator on the bank’s website to help buyers determine whether their desired vehicle fits their budget, and added that banks offer the flexibility to pay off the entire loan at any time with no penalty.

“When it comes to financing a new vehicle purchase, consumers have many options,” Adam said. “Doing your homework before you buy a vehicle can save you a lot of money. Take the time you need to find the right wheels and the right financial fit.”

The overriding message from all sides is to be sure you come into the car shopping process knowing your limit and your tolerance for length of term, and don’t let a salesperson try to talk you out of it.

“Try not to stretch too much,” Lancaster said. “Go out and pick a vehicle that fits your budget and lifestyle.”