In times of soaring inflation, how large a car loan should you take?

Cover fixed expenses first

Olivier Boyd, a licensed insolvency trustee at MNP, believes that fixed expenses must be prioritized.

“You should be able to make ends meet and make sure all your other fixed expenses are covered,” Boyd advised. “Anything above that, then you're entering a territory where it's probably going to be that you have to be sacrificing something else,” he added.

In addition to using common sense, the general wisdom says that people should budget 10% to 20% of their gross pay for their vehicle each year.

For example, a person making $30,000 a year, should probably budget no more than $400 a month after deductions and taxes, and factoring in the insurance, elaborated Boyd.

While this “rule of thumb” can be applied everywhere, it could change in an urban setting where housing costs could possibly take up to 50 or 60 percent of one’s income. This situation would make getting a car a less wise option, Boyd said.

This sentiment is shared by Brian P. Doyle, president and co-founder of Doyle Salewski Inc. Doyle describes himself as a “pessimist” since he expects a lingering “major recession.” People who live in urban areas with enhanced public transportation are better off getting rid of the car expense when possible, Doyle says.

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Budget for unexpected expenses

Getting an auto loan also means factoring in interest rates and credit scores, and the impact that these cumulative expenses will have on your budget.

Doyle also emphasizes the importance of leaving some money for unexpected expenses in case of the “wheels coming off.” This emergency stash is highly recommended for people with older cars that will likely require maintenance.

Car owners must also be mindful of how much money they have set aside for any unexpected health-care costs, since car expenses can eat into this reserve.

“These [incidents] are a part of life and people don't factor that into their budgets, so they don't have the cushion,” Doyle said. “They often budget themselves down to, you know, the smallest amounts.”

Avoid predatory interest rates

While 6% to 8% interest rates are reasonable for auto loans, anything higher would land the buyer in the “risky category or second-tier lending, the most common term we are hearing,” said Boyd.

Equifax Canada’s 2022 Market Pulse Quarterly Credit Trends report revealed that non-bank auto delinquencies went up 14.7% in the last quarter of 2021 (in comparison to the same period the year before). This means more people struggled to repay their car loans.

Many dealerships or independent lenders will be happy to offer financing for vehicles that could result in bad credit for users. Prospective car buyers can avoid this trap and look into bank programs that cater to people who are “cleaning up their act” and taking charge of their debt.

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Read your documents with caution

While the general advice is to get an auto loan from a reputable dealer — who most likely is going to be working with a credible financial institution — Doyle said people need to be aware of hidden costs that can balloon overtime.

“There are many [auto dealers] out there now who are still reputable, but there are some out there which are predatory, and that's why people have to be careful,” Doyle cautioned, citing certain payday loans as an example.

“We see that a lot in our practice,” Doyle added. “We get people who are paying 45%, 50%. They're paying penalties. They take out a loan for $500 and now they have to pay $5,000 back.”

Doyle also urged people to carefully review their documents, be it from a reputable lender or otherwise, to avoid hidden or surprise costs.

“Is it going to be the interest rate? Is it going to be the penalties? The administration charges? Are you getting less for your trade-in than the true market value? Are you paying more for your new vehicle?”

Set your financial boundaries early

Doyle recalled an incident in 2006 when he wanted to buy a Mini Cooper as a gift for his wife’s birthday. The monthly charge was $400. However, the bank at the time wanted to charge his bank account for any amount they thought was reasonable.

“I said, ‘No.’ They can charge me for the amount that's on the loan, which was $400,” he said. “I am not going to give them that right.”

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

Beware of negative equity

When asked what leads to people being unable to pay their loans, Boyd pointed to one common factor: “When negative equity is being passed around.”

Negative equity is what happens when people get a new car but haven’t paid back their previous vehicle. The driver then often ends up defaulting, since they are paying for two cars.

“So a car worth $15,000 or $20,000 will have maybe a $25,000 or $30,000 loan on it because the previous vehicles still have up to $10,000 payments left on it,” Boyd said.

Having a manageable loan means knowing one’s limits.

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