How high should a car loan be in times of rising inflation?

Owning a car can be convenient, but it can also be expensive

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On average, a car is the second most expensive purchase Canadians make. An important part of budgeting for one is to consider more than the purchase price of the vehicle.

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After all, the 2022 MNP Consumer Debt Index Report shows that less than a quarter of Canadians are confident they could handle an unexpected car repair without going into further debt.

To avoid falling into this trap, consider these tips.

Cover the fixed costs first

Olivier Boyd, a licensed insolvency practitioner at MNP, believes that fixed costs must come first.

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“You should be able to make ends meet and make sure all your other overheads are covered,” advised Boyd. “Anything above that, then you’re entering territory where you probably have to sacrifice something else,” he added.

Alongside common sense, common wisdom says that people should allocate 10 to 20 percent of their gross salary to their vehicle each year.

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For example, a person making $30,000 a year probably shouldn’t budget for more than $400 a month after deductions and taxes and accounting for insurance, Boyd said.

While this “rule of thumb” can be applied anywhere, it might change in an urban setting, where housing costs could potentially account for as much as 50 or 60 percent of income. That situation would make getting a car a less wise option, Boyd said.

That sentiment is shared by Brian P. Doyle, president and co-founder of Doyle Salewski Inc. Doyle describes himself as a “pessimist” as he expects a “great recession” to continue. People who live in urban areas with improved public transportation are better off getting rid of car expenses when possible, says Doyle.

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Budget for unexpected expenses

Getting a car loan also means considering interest rates and creditworthiness, as well as the impact of these cumulative expenses on your budget.

Doyle also stresses the importance of leaving some cash for unexpected expenses in case the “wheels fall off.” This emergency stash is highly recommended for those with older cars that are likely to need servicing.

Car owners also need to be mindful of how much money they have set aside for unexpected health care expenses, as car expenses can eat up that reserve.

“These[incidents]are a part of life and people don’t budget for that, so they don’t have a cushion,” Doyle said. “They often budget for the smallest amounts.”

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Avoid predatory interest

While 6 to 8 percent interest rates on auto loans are reasonable, anything higher would put the buyer in “the high-risk category, or second-tier loans, which is the most common term we hear,” Boyd said.

Equifax Canada’s 2022 Market Pulse quarterly credit trend report revealed that non-bank auto arrears rose 14.7 percent in the last quarter of 2021 (compared to the same period last year). This means more people have had trouble paying off their car loans.

Many dealers or independent lenders are happy to offer financing for vehicles which could result in bad credit for users. Potential car buyers can avoid this trap and look for banking programs aimed at people who “clean up their act” and take on their debt.

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Read your documents with care

While the general advice is to get a car loan from a reputable dealer – who will most likely work with a credible financial institution – Doyle said people need to be aware of the hidden costs that can drive up overtime.

“There are a lot[car dealers]out there now that are still legit, but there are some out there that are predatory and so people have to be careful,” Doyle warned, citing certain payday loans as an example.

“We see that a lot in our practice,” added Doyle. “We get people paying 45 percent, 50 percent. You pay penalties. You take out a $500 loan and now you have $5,000 to pay back.”

Doyle also urged people to carefully review their documents, whether from a reputable lender or otherwise, to avoid any hidden or surprise charges.

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“Will it be the interest rate? Will it be the penalties? The management fees? Are you getting less than fair market value for your trade-in? Are you paying more for your new vehicle?”

Set your financial limits early on

Doyle recalled an incident in 2006 when he was getting his wife a Mini Cooper for her birthday. The monthly fee was $400. However, the bank at the time wanted to debit his bank account with whatever amount it deemed appropriate.

“I said no.’ They can bill me for the loan amount, which was $400,” he said. “I don’t give them that right.”

You can also avoid surprises by asking, “So what happens if I miss a payment?” For example, there are layaway plans where a buyer doesn’t have to pay interest for a year. However, once a payment is missed, the buyer is responsible for high interest on their remaining payments.

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Beware of negative equity

When asked what causes people to default on their loans, Boyd pointed to a common factor: “When negative equity is passed on.”

Negative equity, which is what happens when people get a new car but haven’t paid back their previous vehicle. The driver then often falls behind because he pays for two cars.

“So a $15,000 or $20,000 car might have a $25,000 or $30,000 loan because the previous vehicles still have up to $10,000 in payments left over,” Boyd said.

Having a manageable loan means knowing your limits.

Deloitte’s 2021 Global Automotive Consumer Study found that 35 percent of Canadians do not research their auto finance at all. Research and budget if you want to avoid being a statistic yourself.

This article is informational only and should not be construed as advice. It is provided without any guarantee.

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