Risks to consider when buying a car
Depreciation and negative equity
Cars lose their value, or depreciate, quickly. The value of a new car drops as soon as you drive off the dealer’s lot and it keeps decreasing over time.
By the end of the first year, your new car can be worth 25% less than the price you paid. Within the next four years, your new car will typically lose 15% to 25% of its value each year.
You have "negative equity" when your car is worth less than the amount you owe on your car loan.
Example: Long-term negative equity
Two years ago, you bought a new car worth $31,300. You paid $3,700 in taxes and fees. The total cost of the car was $35,000.
You paid for the car with a $35,000 car loan with an interest rate of 4% for an eight-year term. Your monthly payment is about $425.
| How long you’ve owned the car | Depreciation (25% after 1 year, 40% after 2 years) |
Value of your car | Amount remaining on your loan | Amount of negative equity |
|---|---|---|---|---|
| 0 years (brand new) | $0 | $31,300 | $35,000 | $3,700 |
| 1 year | $7,825 | $23,475 | $31,200 | $7,725 |
| 2 years | $12,520 | $18,780 | $27,300 | $8,520 |
*This example is for illustrative purposes only.
In the example above, after two years, your car would be worth $8,520 less than what you owe on your car loan. It takes longer to get out of a negative equity situation in a long-term loan.
Graph: Negative equity comparison on a $31,300 car with a 4% interest rate
Text version: Negative equity comparison on a $31,300 car with a 4% interest rate
| Year(s) since purchase | Value of car | Loan balance (5-Year Term) | Loan balance (8-Year Term) |
|---|---|---|---|
| 1 | $31,289 | $35,357 | $35,357 |
| 2 | $20,139 | $28,838 | $31,530 |
| 3 | $17,008 | $22,055 | $27,547 |
| 4 | $15,205 | $14,995 | $23,401 |
| 5 | $10,641 | $7,647 | $19,087 |
| 6 | $9,021 | $0 | $14,597 |
| 7 | $7,837 | $0 | $9,925 |
| 8 | $5,236 | $0 | $5,061 |
| 9 | $3,478 | $0 | $0 |
This example illustrates how a long-term car loan may extend the period during which you have negative equity. With a five-year loan, you have positive equity sooner. So the value of your car is higher than the amount you owe during the fourth year. With an eight-year loan, you have negative equity until the seventh year.
The financial risks of negative equity
If something unexpected happens and you need to sell your car quickly, you may lose money. If your car is worth less than the amount you owe on your loan, you might have to borrow money to cover the difference between what you can sell your car for and what you still owe on it.
If you get into an accident and your car can’t be repaired, the money you get from the insurance company may not cover what you still owe on your car loan. For example, if your insurance company decides the replacement value of your car is $10,000 but you still owe $16,000 on your loan, you will need to cover the $6,000 left on your loan.
If your car is worth less than the amount you owe on your loan and you trade in your car to buy another, you may end up paying extra money. You might need to borrow to pay for the new car and cover the amount still owing on the old loan, which could add up to a larger loan and more interest charges. This could result in even more negative equity.
Risks associated with long-term car loans
Car loans with terms of 72 months (6 years) or more are considered long-term loans.
Pros and cons of a longer-term car loan
Before taking out a long-term car loan, compare the pros and cons.
Pro
- you may have lower regular car payments
Cons
- may encourage you to buy a more expensive car than you need
- you will pay more interest over the term of the loan
- you will lose money if your car is worth less than the amount you owe on your loan when you sell it or trade it in
Paying more for the same car
The total cost of the car will be higher if you choose a longer-term loan because of the interest you will pay over the loan's term. In the example below, you would pay more than twice as much in interest, increasing total cost by more than $2,700.
| Price of the car | Interest rate on the loan | Term of the loan (months) | Total interest paid | Cost of the car with interest |
|---|---|---|---|---|
| $25,000 | 5.00% | 36 | $1,974 | $26,974 |
| $25,000 | 5.00% | 84 | $4,681 | $29,681 |
*This example is for illustrative purposes only. Amounts have been rounded to the nearest dollar.
Buying a more expensive car
In the example below, the regular payments are identical even though the first car is nearly twice as expensive as the second one. In the case of the first car, you would need to ensure that you could afford the regular payments and all the other ongoing costs for twice as long and be comfortable paying close to $3,500 more in interest.
| Price of the car | Interest rate on loan | Term of the loan (months) | Regular payment | Total amount paid |
|---|---|---|---|---|
| $29,775 | 5.00% | 72 | $479.50 | $34,524 |
| $16,000 | 5.00% | 36 | $479.50 | $17,262 |
*This example is for illustrative purposes only.
Reduce the risks of auto-financing
Here are some things you can do to avoid the risks associated with financing a car:
- buy a car that you can reasonably afford
- choose the shortest term loan you can afford
- pay some money up front when you buy the car
- consider whether buying a new or used car is your best option
- consider whether your needs may change in the future – for example, you may want to have children at some point and need a larger car
- avoid trading in your car if the amount you owe on your loan is more than your car is worth
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