The Car Loan Bubble?
A latest report from Edmund's said that 1 in 3 cars traded-in has an average negative equity balance of $4,832
Do you remember what caused the 'Global Recession' in 2008? Well if you do then good job! But, if you don't know... the answer is the US housing market crashing. In a nutshell, it was a result of individuals defaulting on their loans. Hundreds of thousands of people had mortgages that were suddenly of more value than the value of their homes so they simply walked away from their homes and defaulted. They were all in NEGATIVE EQUITY positions.
Now picture this.... the same thing happening all over North America however - it involves car loans instead of mortgages.
*It is important to note that during the Opening of the Canadian International Auto Show 2017 remarks by Canadian Black Book warned dealers of the looming issue regarding negative equity.*
Negative Equity is when an asset's value falls below the value of the initial loan used to purchase that asset.
Negative Equity has always existed - but just recently has it become a looming problem within the North American markets. Just within 2017 alone - major publications have said:
1. Negative Equity Trade-Ins Spike to Record High
2. Buying a Car with Negative Equity
3. American car buyers are borrowing like never before—and missing plenty of payments, too
4. Risks associated with depreciation and negative equity
The following are recent remarks from Moody's warning Canadian banks about the increased risk exposure on their books-
"A combination of low-interest rates and longer loan terms encourage consumers to purchase more expensive vehicles, leaving many consumers exposed to the risk of overextending their finances and increasing their debt burden, [...] In the event that consumer delinquencies in auto loans rise, negative equity will increase losses to Canadian banks"
Why all of the sudden is there a concern?
A report from Edmunds said that 1 in 3 cars traded-in has an average negative equity balance of $(4,832). That means that around 30% of the cars on the road are in a negative equity position.
The Cause
Lengthen contract terms from the 4-5 years to 6-8 years. People want a Cadillac for the Chevrolet payment, per se.
When going into a dealership - a lot of people are concerned about their monthly payment rather than their total payment. So, some car dealers try to take advantage by stretching a loan as far as possible and decreasing the monthly payments. The problem is you end up paying more in interest.
Should you be worried?
On January 8, 2017 the Financial Consumer Agency of Canada on behalf of the Government of Canada issues an article titled "Risks associated with depreciation and negative equity"
Imagine you just paid $35,000 for a new car two years ago by taking out a 8 year, 4% car loan. Today the car is worth $19,000 but, you still owe $27,000. You are in an equity position of $8,000. Ouch!
Here is a visual representation:
Graph: Negative equity on a $35,000 @ 4% interest rate. Contract lenght comparision.
So what can you do if you are in a negative equity position? Well, you can roll it into a new car loan and simply refinance again. Without realizing it, you're making a terrible financial move. Off the bat, your loan amount may be as high as 120% of the car's initial value - and this value is highly likely going to drop.
What happens if you get into an accident and you have a loan? An insurance company will pay out what they assume the value of your car to be - not what you have outstanding on the loan. Uh oh!
What should you do!?
If you are in a negative equity position you have 1 financially efficient choice.
- Drive the car to the ground and pay off the loan.
But, if everyone starts doing that then you will get another issue - keeping people out of the car market for a longer time period, resulting in a cool down in car demand.
That's not good for the entire automotive industry and the economy!
In Summary
Is there a car loan bubble? Unfortunately Yes! However, when will it burst and what will happen? Those are the most pressing questions.
Negative Equity can impact us all! The keys are to:
- Educate consumers about depreciation and contract terms lengths.
- Make it mandatory for dealers to explain how lengthening your contract terms changes your circumstances.
- Be aware that the last few years were record years in terms of car demand in North America, so...
- Expect a slow down in the automotive industry because an increased amount of people will be out of the market for a longer period of time.
“Rule No. 1: Never lose money.
Rule No. 2: Never forget rule No.1.”
