Here’s what happens to your car loan if interest rates rise

Higher interest rates could exacerbate the current trend toward longer and longer amortization periods on car loans.
Higher interest rates could exacerbate the current trend toward longer and longer amortization periods on car loans. AP Photo/Steve Helber

Interest rates will likely rise on Wednesday, July 12 at 10 a.m. That’s when most economists expect the Bank of Canada will raise its key rate from the current 0.5 per cent, where it has been since July 2015, to 0.75 per cent.

Canadians with variable-rate mortgages and home equity lines of credit would likely be the first to feel the pinch of higher interest rates.

READ MORE: What you need to know about mortgages if interest rates rise

But homes aren’t the only reason Canadians have been piling on debt. Another major source of red ink for consumers’ budgets are auto loans.

Light vehicle sales in this country have been shattering record after record since 2013, but Canadians are using debt to finance fully 85 per cent of those purchases, according to DesRosiers Automotive Consultants.

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READ MORE: Interest rates could rise July 12: Who are the winners and losers?

So what does pricier debt mean for car loans?

Watch your amortization period

Most auto loans have fixed payments, according to Michael Hatch, chief economist at the Canadian Automobile Dealers Association (CADA).

However, lenders often also offer care loans with variable interest rates that move up or down with the general level of rates in the economy. But while having a variable-rate mortgage means your monthly payments go up if interest rates rise, with most variable-rate car loans debt repayments remain the same. Instead, if rates climb, it’s the length of the loans (called amortization period) that will stretch out.

READ MORE: Interest rate hike: Most Canadians would struggle to pay just $130 more a month, survey shows

Canadians with variable-rate auto loans won’t see any difference in their monthly payments but it will take them longer to pay off their vehicles.

But rising interest rates might have an impact for consumers who choose fixed rates as well.

“It’s possible” that a sustained increase in interest rates would encourage Canadians to opt for longer loans, which have lower monthly payments, Hatch told Global News.

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Consumers have already been taking on lengthier and lengthier loans over the past few years, even as interest rates declined.

The average loan term for new vehicle purchases reached six years in 2015, up from traditional amortization periods of four to five years, the Financial Consumer Agency of Canada (FCAC) noted in a 2016 report. And loans as long as eight years are becoming increasingly common.

READ MORE: Longer car loans lower payments, but raise risks, consumer agency says

Longer loans increase the chance that borrowers’ financial situation will change and they’ll miss a payment, said Douglas Hoyes, a licensed insolvency trustee at Ontario-based Hoyes Michalos.

It also means consumers will need to stick with their cars for longer in order to fully pay off their debt, he noted.

The trend toward ever-longer amortization periods is “the biggest issue” facing consumers right now, Hatch told Global News.

Higher interest rates could exacerbate that trend.

WATCH: Who would higher interest rates benefit and who would they hurt?

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Bank of Canada may raise interest rates: Who are the winners and losers?

An upward incline on the ‘auto-debt treadmill’

Canadians may be getting into longer auto loans, but many aren’t waiting to for their balance to hit $0 before purchasing a new vehicle, statistics have shown.

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Instead, they are getting new loans that cover both the cost of their new ride and the unpaid portion of their old car loan.

Since cars depreciate quickly once driven off the lot, borrowers who trade in their vehicle before the end of their term loan generally end up owing money even after they’ve sold their old car, a financial conundrum economists refer to as “having negative equity” or “being underwater.”

READ MORE: TransUnion report: Auto loan delinquencies rise in Alberta, Sask.

The share of Canadians trading vehicles with negative equity was 30 per cent in 2015, up from 20 per cent in 2010, according to statistics from market research company J.D. Power.

This “auto-debt treadmill,” as the FCAC called it, is bad enough in and of itself. Consumers are “perpetually servicing debt associated with the vehicle they drive, or used to drive,” the consumer watchdog has noted.

But things would get worse with an interest rate increase.

That’s because Canadians would carry over their negative equity into a new loan that would have higher interest rates, noted Hoyes.

In other words, the auto-debt treadmill would start to tilt upward.

READ MORE: High monthly payments, long loans grease Canada’s auto boom

Auto-loan rates unlikely to move as much as mortgage rates

At CADA, Hatch told Global News that fierce competition in the industry means consumers likely won’t see as much of an increase in auto-loan rates as in mortgage rates.

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Some lenders may even be able to absorb the full impact of a BoC first interest rate.

And cars these days last longer, allowing consumers to take longer to pay for them, he added.

It may be why Canadians are less likely to default on their auto loans than they are on any other type of non-mortgage debt. The delinquency rate currently stands around 1.5 per cent, according to Hatch.

Still, with households burdened by record amounts of debt, higher borrowing costs will force many Canadians to take a harder look at just how much car they can afford.

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