Recent data from BMO Economics shows that luxury car sales have climbed a staggering 37 per cent since 2013. This spike in sales has been driven by two major factors: extended car loan terms with “low” payments and by customers who experience a “wealth effect” (where they feel wealthier than they actually are on paper). And instead of paying cash for these expensive vehicles, people are signing up for long-term car loans to make hefty payments on these pricey autos more “affordable.”
While most of the buying public isn’t out to buy a luxury car (classified as $90,000 and up), these recent statistics bring to light some important points to consider when shopping for a car. It doesn’t matter if you are in the market for a used mini-van or a sleek sports car; the principles of good money management are the same. Don’t buy too much car. Only buy as much as you can afford, based on your income.
“A car purchase falls into a bit of a grey area in terms of good debt and bad debt. It’s “good” in the sense that it is debt that is tied to an asset. It’s “bad” in the sense that the asset value quickly depreciates. Your take home should be that it is not a good idea to have a car loan that extends for a long period of time,” says Jeff Schwartz, executive director, Consolidated Credit Counseling Services of Canada.
“The auto industry utilizes smoke and mirrors to entice buyers, so in order to avoid taking out too much debt, you’ve got to be a savvy shopper when you are looking for a car. Establish a budget based on what you can afford as it relates comfortably to your income, not based on other factors,” says Schwartz.
Here is how you should approach your car search:
The illusions of affordability
Don’t be fooled by a number of the tools that car dealers use to create a sense of affordability. With low interest rates and the ability to extend car loans over long periods of time, people tend to look at what they’d pay on a monthly basis, which seems reasonable, right?
Think again. People tend to focus on the monthly payment, but what you need to look at more closely is the amount of interest and financing charges that you’ll pay out over time. As a rule of thumb, the longer the length of the loan, the greater that amount is. Don’t forget, the more expensive the car, usually means the higher the cost for insurance and maintenance.
The 60 month test
It used to be fairly standard that car loans were extended over 60 months, more or less. But over the years, lenders have quietly extended the loans up to 72 or 84 months.
Part of the reason that lenders had targeted 60 months is the resale amount on a car beyond five years old declines rapidly. If possible, aim to pay a car loan off within 60 months (less if it is manageable). Try it out. Can you afford payments on your car for 60 months with the balance totally paid off? If your car loan payments are unaffordable within that 60 month range, then you are shopping outside of your price range.
Offset the debt
Still lured by that shiny car? There are other ways to make those monthly payments lower. Save up for a more substantial down payment.
You might even want to trade in that new car smell for more cash in hand. If you buy a used car (even a year or two old) you can get a lot of the same features for a deep discount.