I've been looking to replace my 8 year old minivan and I am amazed at the number of financing options available when it comes to buying a car, especially a new one. Over 25 years ago when I was looking to buy my first real car, I was coached by my mom and dad (non-financial experts) to save the money and pay cash. I was looking at a Volkswagon Jetta or a Mazda 626 and was going to spend about $12,000 for a used one. As I was shopping at some car lots, I was encouraged to take out a car loan and the longest I could finance for was 3 years.
Times have changed. Car prices are much higher but the bigger change surrounds the financing options to take home a car off the lot. Today, we can lease cars with no money down or if we prefer to buy, we can finance cars for much longer than 3 years. In fact, we can spread payments out for as long as 96 months (8 years).
Why are longer amortizations so attractive?
Simply put, it makes cars more affordable. Let's look at an example of a $30,000 car. If financed over 3 years, the payments would be $899.13 per month. If you extend the car loan to 8 years or 96 months, the monthly payments drop to a more manageable figure of $379.80 per month.
Related article: Why 40 year mortgages were such a problem
What's interesting is advertisements no longer show the price of the car but rather the affordability of the payments. Most car companies are now advertising the bi-weekly payment of $189.90 instead of the monthly payment of $379.80. Without any other information, which looks more appealing for the same car? “$30,000”, “$899.13 per month” or “For as low as $189.90 bi-weekly”?
Longer amortization periods: How much is it costing consumers?
Unfortunately we live in a world where we make purchases based on the affordability of payments rather than understanding something I call total cost.
When financing a purchase, the total cost includes the cost of financing. For example, when we buy that $30,000 car and finance it for 3 years, the total cost of the car is $32,368.57 because the interest cost over 5 years is $2368.57 (assuming a 5% interest rate)
If we buy that same $30,000 car but now finance it over 8 years or 96 months, the total cost goes up to $36,460.57 based on monthly payments and $35,700.97 based on bi-weekly payments.
Now which would you rather pay for the same car? “$30,000”, “$32,368” or “”$36,460”?
The right answer is we need to look at a number of different issues when buying a car but my point is too often we get lured by the affordability of payments without proper consideration of the total cost of financing.
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Growth of car loans have outpaced other consumer debt
According to some data in this Globe and Mail article, auto loans have almost doubled in eight years to more than $120-billion amid growth that has outpaced other forms of household debt.
In the article, a bank representative said in its Financial System Review that it has “modest concerns” about the rise in auto debt, but “the recent changes in the auto financing landscape warrant continued monitoring in the context of already high household indebtedness, particularly if the debt is being incurred by borrowers who are already stretched financially.”
The bank representative said two factors are being watched closely:
- The growth of loans to people with low credit rising to 25 per cent of the market, and risky practices such as longer term loans and loans that are becoming a higher percentage of the total value of a vehicle.
- The growth of longer-term car loans that stretch as long as eight years has helped propel the Canadian market to record sales that are expected to top 1.8 million vehicles this year, but some auto makers are trying to encourage buyers to take shorter terms or lease vehicles instead of buying them. The longer the term of the loan, the lower the monthly payment, which is the key element in consumers’ minds as they consider new vehicle purchases.
New record debt levels again
Most recently, Statistics Canada released new data showing that Canadian household debt rose again and the debt to income ratio is another record high of 164.6%. That means that Canadians owe just under $1.65 for every dollar of their disposable income .The ratio increased because while incomes rose by 0.8 per cent, so too did Canadians' debt levels, which increased by 1.8 per cent.
Related article: Record debt levels: Is it really a problem?
Not only should Canadians pay attention to the total amount of debt they have but they also need to pay attention to the length of amortization for all loans, especially car loans and mortgages.