The astronomical levels of household debt we've built up in the past few years can be explained to some extent by something we'll call the affordability delusion.
That's where people buy things they can't properly afford using loans that are repaid over an extended number of years. Cars are a perfect example. A typical car loan used to be five years at most in length. Now, data from the research firm J.D. Power and Associates show that 57 per cent of buyers are going with terms of six years or longer.
Delusional is the word to describe the view that this is the right way to pay for a car. True, the monthly payments on a car loan become more manageable as you extend the term. But the added interest costs work against your long-term financial health, as do several more subtle factors:
Maintenance: No more cheaping out on service; if you don't spend the money to take good care of a car you'll own for seven or eight years, you run the risk of expensive repairs.
Resale value: If you drive 30,000 kilometres a year, you'd have almost a quarter-million kilometres on the clock after eight years; in other words, the car would have pretty much zero value in the eyes of potential buyers.
Fuel costs: You're denying yourself the benefit of fuel-saving technology that becomes available in the years ahead, even as gasoline prices keep rising.
Buying your next car: Trading car in before the loan is paid puts you in a position where you're financing both the old vehicle and the new one.
The more expensive any item is to buy, the more attractive it is to borrow over an extended period of time. That's why 30- to 40-year mortgages were hugely popular with first-time buyers when they were widely available.
Borrow $25,000 for a car at 4 per cent and you end up with a total interest bill of $2,625 for the five-year term and $3,704 for seven years, or $1,079 extra. The short-term payoff: Monthly payments of $342 over seven years instead of $460 over five years.
Monthly payments are the main focus in borrowing today. "It's about people trying to manage their cash flow," said Brian Murphy, senior automotive manager at J.D. Power. "They want to do other things with their money – they want to go on vacation."
We want it all. And if we keep fixating on monthly payments, we'll delude ourselves that we can actually afford it. Net result: Endless debt that leaves us too little room to save.
Consider the opportunity cost of making hefty monthly payments for seven years instead of five. The extra 24 months' worth of payments is money you could divert to retirement savings, to your child's registered education savings plan or to repayment of other debts such as your mortgage. Even worse is the fact that lots of people aren't waiting until their car loans are paid off to buy something new. Mr. Murphy said 26 per cent of buyers today are "upside down," a car dealer's term for owing money on a car that is being traded in for another. That's up from 16 per cent in 2007.
Mr. Murphy said that if you still owe money on a car but want a new one, the dealer may help you pay what you owe to seal a deal. Or, the amount owing is added to your new loan principal. It's conceivable that someone could be paying for three cars at once – a new one, plus residual amounts on two previous loans.
Car buyers used to be able to keep their payments small by leasing, but that option has become less available in recent years because it's not cost-effective for automakers and dealers. Don't underestimate the impact of the affordability delusion, though.
According to J. D. Power data, the average down payment on a financed car has fallen to $4,768 this year from $5,126 in 2010. The price of cars edged up a bit over that period, but buyers were actually saving less for the purchase. Why save for a down payment when a loan term of six to eight years guarantees affordable monthly payments?
Our problem here in Debtor Nation is not borrowing, per se. When buying expensive things like cars, it's almost unavoidable. Where we get into trouble is believing the cost of debt is measured only by our monthly payments. That's delusional.
Lower payments, higher costs
Car prices have been moving higher, but you won't see that reflected in the down payments people are making, or in their monthly loan payments. The reason is that car loans are being extended to as long as eight years these days. The longer the loan, the easier a car is to afford on a monthly basis.
Total down (%)
* less customer cash rebate (all nameplates). Source: J.D. Power & Associates