In Canada, there are three ways to pay for a car. One is by paying in cash, which is ideal because it leaves you without debt. However, cars are not cheap things – they’re often the second-most expensive purchase someone will make in a lifetime after a home – and the average Canadian doesn’t have that kind of money waiting to be spent on a new vehicle.
The second method is leasing. When you lease a car, you don’t own it. Instead, you’re paying to use it for a certain period of time, and you have to give it back to the dealer at the end of that period while meeting a set of conditions. If you don’t meet those conditions – say, you need to return the car early or you cover more than the agreed amount of kilometres – it can create a lot of headaches.
The third route for purchasing a vehicle is financing, and more than half of Canadians buy new or used cars this way. Here’s everything you need to know about how to make car financing work for you.
How Does Car Financing Work in Canada?
- Why Would You Finance a Car Instead of Paying Cash?
- What is Car Financing?
- What do I Need to Qualify for a Car Loan?
- Choosing a Term
- What is the Loan Principal?
- Understanding Interest Rates
- Should I Finance Through a Car Dealership or my Bank?
- I Already Have a Car Loan. Can I Get a Better Interest Rate?
- What is Negative Equity?
- Does Financing a Car Hurt Your Credit
Why Would You Finance a Car Instead of Paying Cash?
People choose to finance because it means the loan can be paid back on terms you agree to in advance with your lender, and when the loan is paid off, you own the car. At the end of the term, you can decide to drive it until it’s ready for scrap or you choose to sell it. It’s your car, so what you do with it is entirely up to you.
What is Car Financing?
In the simplest terms, financing means taking out a car loan: you borrow money from a lender to pay for the car up front, and then you pay it back to the lender over an agreed period of time.
Both new and used vehicles can be purchased with financing. The loans are usually take the form of monthly payments, although some lenders will set up alternate payment options such as weekly or bi-weekly installments.
What do I Need to Qualify for a Car Loan?
In general, a lender will want to ensure that you live in Canada and are at the age of majority in your home province, that you can provide government-issued identification, that you can prove your income is sufficient to afford the payments, and that you’ve been able to secure insurance for the vehicle. You’ll also need to give the lender permission to check your credit history and verify your credit score.
Choosing a Term
One of the auto financing options you’ll need to choose is the term – or the length – of the loan.
In Canada, car loan terms can range anywhere from two to three years (24 to 36 months) to five years (60 months) or, as we’re seeing more often, seven or eight years (84 to 96 months).
If you choose a longer loan term, you’ll have lower monthly payments, which can make more expensive cars more affordable, but it will take more time until the car is fully yours.
If you choose a shorter loan term, you’ll have higher monthly payments, but they’ll end sooner, and the car will be yours much quicker.
The term for your loan becomes important if you need to sell your car early or it’s stolen or written off in a crash. We’ll talk more about this in the section on negative equity below.
What is the Loan Principal?
When you first take out your loan, the principal is the total amount of the money you’re borrowing. For example, if you need to finance the full purchase price of your new car and it costs $40,000 including the dealer’s fees, plus provincial sales tax – in Ontario this would be 13% or $5,200 – then your initial loan principal will be $45,200.
You can lower this cost by making a down payment at the start of your loan. Some lenders may require this, especially if you’re borrowing a large amount or you have a bad credit score, while others may not. If you have a vehicle to trade in, you can use its value as the down payment for your new loan. In either case, starting with a lower principal means you can either have cheaper payments for the duration of your loan, or you can choose a shorter term and pay it off faster. Both scenarios will save you money in the long run.
A portion of each loan payment goes toward interest and another portion toward paying the principal. The amount of the principal – which is the amount that you still owe the lender for your car purchase – goes down as you make more payments.
Understanding Interest Rates
Interest – also known as APR, which stands for annual percentage rate – is the percentage you’ll pay on the principal on a yearly basis for the life of the loan. It’s how your lender earns a profit.
Interest rates are set by the Bank of Canada and your lender and change on a regular basis. Your interest rate can make a big difference to the actual amount you pay for your car loan. Take a look at the examples below. We used Scotiabank’s auto loan calculator to work out these numbers. Other lenders provide similar tools on their websites.
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If you borrow $40,000 for a car and receive a 4% APR on a five-year term, your monthly payment will be $736.66 and you can expect to pay $4,199.65 in interest.
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If you borrow that same $40,000 for the same term with a 2% APR, those monthly payments go down to $701.11. That may not seem like a big difference in your payments, but the total interest paid over five years goes down a lot, to $2,066.62, so you save $2,133.03 over five years.
There are a few factors that can make a difference in the interest rate you’re offered, such as your credit score (which is based on how good you are about making payments on your other debts, such as your mortgage or credit card), the vehicle you’ve chosen and whether it’s new or used, the length of the loan, and whether you make a down payment, among others. In general, you’ll get a lower interest rate on a new vehicle than on a used vehicle. That’s why it’s important to shop around for the best rates.
Should I Finance Through a Car Dealership or my Bank?
This is one of the most common questions about financing a new car, and the right answer depends on a few factors.
Sometimes, a dealer may offer you a very low interest rate, or even 0% interest. A low promotional rate tends to be connected to a specific vehicle, and only offered to buyers with excellent credit. Since banks don’t offer these kinds of deals, it will save you a lot of money to get your loan through the dealership if these kinds of rates are offered to you. A dealership will also take care of most of the loan application process, which relieves you of some of the legwork.
You may prefer to get finance directly through your preferred financial institution, whether it’s a bank or a credit union, if you’re offered a better interest rate.
However, if you have bad credit, you may have trouble getting a loan approved by your bank or at some dealerships. If they pull your credit report and find a low credit rating, they may be concerned you’re not going to make your payments. In these cases, your financial situation may leave you with no choice but to go to a lender who gives loans to higher-risk applicants at typically higher interest rates. Some new car dealerships have specialized departments to help car buyers with bad credit to secure loans. If you’re concerned that you may not qualify for a loan, it’s worth seeking one of these out.
I Already Have a Car Loan. Can I Get a Better Interest Rate?
Potentially, if you refinance your loan. If you’ve been making your payments steadily for a year or more and you’ve improved your credit score, or if the bank’s interest rates have gone down since you first took out your loan, refinancing may be worth exploring. Contact your lender or your bank to see what may be possible. However, if your car loan is in a negative equity position, you won’t be able to refinance.
What is Negative Equity?
You may have heard the term ‘negative equity’ in news stories about car loans in recent years. It means the amount you owe on the loan is greater than the value of the car if you try to sell it.
Apart from those that come with a large down payment, nearly all new car loans start in a position of negative equity. That’s because your new car loses a lot of its value the second you drive it off the lot, due to a process known as depreciation. As soon as the car leaves the dealership, it becomes a used car, and people aren’t willing to pay as much for it as they would a new one.
As you make payments on your loan, the amount left on your principal goes down. Over time, your principal will reduce to the point where your car is worth more than what you owe. At this point, you have equity in your car and you’re no longer in a negative equity position.
Until then, if something happens and you need to pay off your loan – an unexpected move, a change in family circumstances, a theft, or a write-off in a crash are just a few possible reasons – you’ll get less money for your car than what you owe the lender, and you’ll need to find a way to pay back the difference.
Long-term loans, such as those with a duration of 84 months (seven years) or more, can make this problem worse. It takes longer for the principal to come down to the car’s actual value, which opens up more time for things to go sideways, especially after your manufacturer’s warranty runs out and you need to pay for any unexpected repairs in addition to your loan payments.
Be sure to factor negative equity into your decisions about your new car loan so you don’t get taken by surprise a few years down the road.
Does Financing a Car Hurt Your Credit
So long as you pay back the money owed to your lender on time, financing a car should not hurt your credit rating. Problems arise when people can't make payments or are in a position where selling their car would land them in negative equity with no way to make up the shortfall. If you're struggling with loan payments it's important to speak to your lender to see what solutions might be available.