How to Avoid Car Loan Debt

How to Avoid Car Loan Debt

Written by Caitlin Wood
Last Updated October 27, 2020

In recent years the trend towards longer and longer car loans has become more and more popular. It’s the idea that your monthly payments will be more affordable, but in the long run and something that many people do not consider, you’ll be piling on debt you can’t afford. Longer car loans are typically advertised as a means to get a nicer and more expensive car at a more affordable monthly cost. The end result is that people usually end up buying more car than they can afford and spend more on interest than they’d like.

There definitely has been a growth in long-term car loans in the past decade that could be considered troubling. The average car loan term in 2015 was 72 months, compared to only 65 months in 2010. Auto lending is an ever-growing market, 20% every year since 2007 to be exact. Its growth has even exceeded mortgages, lines of credit and credit cards. In the past seven years, the vehicle loan industry has grown from $16.2 billion to $64 billion.

Check out how you can cut the cost of your car.

How Long Term Financing Affects Debt?

As mentioned, when you choose a longer-term loan, you pay more in interest. While it may provide a lower payment on a month-to-month basis, the overall cost of a long term car loan vs a short term loan is significantly higher. 

For example, assume you want to buy a $20,000 car with a down payment of 15% and an interest rate of 7.5%.  Do you know how much more you’ll pay in interest for an 84-month loan term vs a 36-month loan? Based on our calculation below, an 84-month car loan would lead to almost $3,000 dollars more in interest. While it does provide much lower payments, your ultimately taking on more car debt. 

 84 Months36 Months
Car Price20,00020,000
Down Payment (15%)3,0003,000
Amount to Finance17,00017,000
Interest Rate7.5%7.5%
Monthly Payment$260.75$528.81
Total Paid21,90319,037.16
Total Interest Paid$4,903$2,037.16

The Negative Impact of Negative Equity

Car loans can have negative equity and positive equity. Negative equity is when you owe more on the car than it’s worth and positive equity is the opposite. When you first get your car your negative equity is at the highest because you haven’t made any payments yet and because cars depreciate in value so quickly.

However, by around the fourth year of a standard 60 month loan, you will move into a positive equity position. This is a great place to be as you owe less than the car is worth. The thing about long term car loans is that your equity loops back into being in a negative. The reason for this is because your car continues to depreciate in value but you’re not paying it off quickly enough. This is without a doubt something that you want to avoid.

Separating the Good from the Bad

This is not to say that all car loans are bad, but there certainly is a right way and a wrong way to go about doing them. The best thing you can do for yourself and your future finances is to put yourself in a position where you know exactly what’s going on and you won’t be tempted into taking on a longer loan term just to decrease your monthly payments. The great news is that after reading this article you’re already on your way to being significantly more informed than a large portion of the population.

There are many costs to consider when getting a car. Check out how to budget for a car

Learning How to Avoid Car Loan Debt

The simple truth is that most Canadians will have to borrow money at some point in their lives.  What is important is that you don’t get seduced by debt traps that advertise high-end vehicles with alluring low-cost options. These pointers should keep you on the right track to avoiding car loan debt.

Only Buy a Car You Can Afford

Don’t take out a loan on a car that will put you even further in debt down the road. Always remember that a 60-month loan is ideal. Also, keep in mind, it’s normal to have negative equity at the beginning of your loan, but you want that to convert to positive equity by the end. A good way of determining how much you should spend on a car is by using the 20/4/10 rule. The 20/4/10 rule is a car budgeting rule that Canadians use to avoid taking on too much debt. The rule dictates that you should always put at least 20% down, have a term of no more than 4 years and that your monthly car payment shouldn’t exceed 10% of your income.

Are you paying too much? Find out if your monthly car payment is too expensive.

Put More Cash Down Upfront

Ideally, you should aim to put down 20% when you`re buying a new car. However, the more you’re able to put down the less you’ll need to finance. It also gives your lender more security which could translate to better terms and rates. Moreover, larger down payments will help you avoid negative equity.

Learn more about how much cash you should put down for you car.  

Avoid Long-Term Financing

This point has already been made but it’s worth repeating. Most people are seduced by the longer terms because they want to avoid making larger payments but as we`ve discussed, a shorter term means you’ll be saving money in the long run.

Research Your Financing Options

Before accepting the terms of a car loan, take some time to research and compare your financing options. There are a number of different lenders available who provide car loans including banks, dealerships and online lenders. If you have bad credit, getting pre-approved with different lenders can help you score a lower rate.

You should also conduct research on the car you want as well. Understanding the average market price of your car can ensure you won’t be overcharged by your dealer. You’ll have the information you need to properly negotiate your car price.

Learn more about what questions you should ask your dealer when buying a car

Auto Financing 101

Paying off your Car Loan ASAP

Once you have been approved for a car loan, the next step is to start paying it off as soon as you can. Here are a few different ways you can speed up your auto loan repayment.

Lump Sum Payments

Making lump-sum payments whenever you have the opportunity will allow you to pay off your loan more quickly. These payments are not totally set, and can be made at the convenience of the borrower. In the long run, you’ll end up paying less interest.

Increasing Your Payments

Making larger monthly payments will reduce the length of your auto loan debt. The more you increase your monthly payments, the more you are speeding up the paying off process. Ultimately your goal is to own a reliable and convenient vehicle out right. If you manage your finances well and raise your monthly payments, this goal can become a reality sooner than later.

Downsizing Your Vehicle

There is also the possibility that the reason you`re having trouble with repayments is not your loan, but the car itself. If the size of your loan is too big, to the point where you can’t pay it off, then it`s possible your car is not reflective of your income. If this is the case, you may want to consider either selling or trading in your car for something more cost-efficient. This move will significantly reduce your monthly payments. With a smaller loan, you will be able to make consistent payments and pay off your loan far more quickly.

Check out how an auto loan can help you rebuild credit

The Bottom Line

In the end, improving your financial position and paying off your car loan as quickly and effectively as possible should be your primary concern. Always keep in mind that your auto loan should not exceed a certain time commitment, be realistic with your car choice, and, if possible, make lump sum payments whenever some extra cash frees up.  If you follow these basic guidelines you’ll be on the right track to successfully paying off your auto loan.

Looking for More Information on Auto Financing in Canada?

In you’re currently looking into purchasing a new car or are interested in more information on auto financing take a look at our online application.


Rating of 5/5 based on 4 votes.

Caitlin is a graduate of Dawson College and Concordia University and has been working in the personal finance industry for over eight years. She believes that education and knowledge are the two most important factors in the creation of healthy financial habits. She also believes that openly discussing money and credit, and the responsibilities that come with them can lead to better decisions and a greater sense of financial security. One of the main ways she’s built good financial habits is by budgeting and tracking her spending through the YNAB budgeting app. She also automates her savings so she never forgets to put aside a portion of her income into her TFSA. She believes investing and passive income is key to earning financial freedom. She also uses her Aeroplan TD credit card to collect Aeroplan points so that she can save money when she travels.

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