Long-term auto loans pose risks to Canadians: report

Canadians drawn by the allure of long-term loans face the risk of stepping onto an "auto-debt treadmill," according to a new federal report.

Published by the Financial Consumer Agency of Canada (FCAC), Auto Finance: Market Trends finds lower monthly payments on finance agreements longer than five years are leaving consumers "increasingly comfortable buying 'more car' than they may be able to afford," while buying new vehicles before existing loans are repaid.

"While Canadians are paying for their vehicles over these extended periods, research shows that they are not keeping them longer," FCAC commissioner Lucie Tedesco said in a statement accompanying the report.

"Many continue to trade in their vehicles after only four or five years, when they might owe more on their vehicle than their vehicle is worth."

Longer terms and lower payments, Tedesco continued, can create "a false sense of affordability" among consumers.

The country's auto finance market as a whole has nearly doubled over the last eight years, the report reads, while extended-term loans now account for more than 60 per cent of the auto loan portfolios of Canada's largest lenders.

More than 70 per cent of new auto loans are for terms longer than five years, it continues.

Total transaction prices for new vehicles in Canada is growing at more than twice the rate of average monthly payments, according to the report, with longer loan terms squarely to blame.

The report, citing data gathered by J.D. Power, shows the average transaction price of a new vehicle in Canada spiked by roughly 14 per cent to $34,190 between 2010 and the second quarter of 2015, while the average monthly payment in an extended-term loan—defined as having a term length longer than five years—grew by only seven per cent, from $458 to $518, over the same period.

The growing popularity of long-term loans is also leaving consumers focused on monthly payments as opposed to the overall costs of different types of vehicles, it continues.

Comparing a $16,000 economy car financed over a three-year term at an annualized interest rate of three per cent to a $32,000 midsize sedan financed over a six-year term at the same three per cent annual percentage rate, an example contained in the report shows that while monthly payments are similar—$465 for the former and $486 for the latter—the interest charges differ greatly.

While the interest on the economy car totals $750 over the course of three years, the interest on the midsize sedan is 400 per cent more, at a whopping $3,000.

"The growing number of consumers who extend their car loan payments over terms of seven, eight or nine years ... expose themselves to paying more than they would if they opted for a more traditional loan term," Tedesco's statement continued.

The report says long-term loans are particularly expensive for consumers with low credit scores.

"When high interest rates are combined with longer terms," it reads, "consumers can find themselves with loans that cost twice as much as the vehicle they bought."

Comparing prime and non-prime loan costs, an example in the report shows that the total interest on a $21,000 vehicle at a three per cent rate over seven years totals $2,300, a little more than 10 per cent of the purchase price.

At a non-prime rate of 25 per cent, however, the interest on the vehicle over the same term totals $23,000, while monthly payments nearly double to $532 compared to $278.

What's more, the report claims that consumers carrying negative equity—when the value of the vehicle is less than the amount owing—may not be able to obtain financing.

"There are limits on the number of times consumers can roll over negative positions before they begin exceeding lenders' risk threshold," the report reads, noting that carrying negative equity from a previous auto loan once usually isn't a problem.

"However, it is much more difficult to roll over negative equity positions a second time, and almost impossible to roll them over a third time."

Interest rates rising from their historic lows in the future could further trouble matters, increasing the potential for a "credit crunch" in the auto finance market, according to the report.

The FCAC report also takes issue with the way in which indirect auto loans—finance agreements brokered by dealers on behalf of banks—are being executed in Canada, where dealers earn a commission from the lender, rendering the consumer powerless to choice between competitive offers.

The report claims more than half of the new vehicle purchases across the country in 2015 were indirectly financed by federally-regulated financial institutions.

In response to the "concerning" trends in auto financing, the report highlights the FCAC's plan to "improve consumer protection and education" that includes better supervision of indirect auto loans offered by federally-regulated banks, and new educational material "to help consumers make more responsible decisions" when it comes to auto finance decisions.