Financing a car on debt – what you need to know

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With the growing demand for cars in South Africa, many aspiring car owners sort for the car loans as a method of financing their cars. This is contrary to the fact that it is relatively expensive to finance a car with a loan instead of paying on cash. Financing a car on debt is mainly due to several reasons like affordability and the availability of cash.

You may find our post about buying a car for the first time useful. In this post, we are going to discuss about few things that you need to know if you are considering about taking a car loan.

New cars vs Second hand cars

It is crucial to decide whether you are buying a pre-owned car (used car) or a new car. New cars may give you a better reliability but they are more expensive in terms of cost. The loan amount on second hand cars will be smaller than on new cars . When you take a car loan, the creditor owns the car until you pay it off (this acts as collateral). As a result, since a new car has more value than a second hand car, the creditor will have a bigger collateral which will result in a lower interest rate on new cars than used cars.

New cars lose about 20% – 25% of their value in the first year as a result of depreciation. However, depreciation will decrease with the age of the car. This makes pre-owned cars attractive in the sense that they lose value at a slower rate than a new car.

However, if you are to consider a second hand car, you need to be very careful with your choice. The problem of a second hand car is that the reason why it is being sold may never be disclosed to you. When you are buying used cars, you need to be on the look out for red signals. it is important to ensure that you do not let emotions overpower your thinking. A well polished pre-owned car may look new and this may play tricks on you.

In South Africa, a large proportion of car dealer revenue comes from selling pre-owned cars (data extracted from enatis). In all South African provinces, the used car market is more dominant than the new car market. As shown below, more than 76% of the total registrations between September and November 2019 were for second hand cars.

Insurance

Before you drive any car away from the dealer, you are required to insure it first. Since the car is the collateral on a car loan, the creditor need to be protected against loses that may come as a result of accidents and theft. Therefore, it is a requirement for you to get comprehensive insurance.

Furthermore, it is very important to have a gap cover insurance. What is gap cover? It is a short term insurance that covers the shortfall between the claim settlement from the insurer and the outstanding balance on your car loan. Suppose that you finance your new car worth R 213 000 on debt. Within a month, you crash your car and it is written off. If the claim settlement of the insurance is R 170 000. You will be liable to pay the shortfall to the lender. Gap cover will pay the outstanding balance and allow you to mourn your loss in peace.

Break even point of a car loan

Despite the fact that many car loans are for 5 – 6 years, very few people can drive the same car for more than 5 years. You need to know the break even point of your car. When you are selling your car, you sell at the market value. As pointed out already, the car loses much value in the first 2 to 3 years as a result of depreciation. This depreciation, together with other factors like mileage or the condition of the car will reduce the market value significantly.

Moreover, a new car will generally take a longer time to reach break even point as compared to a used car. The break even duration is the time it takes for the market value of the car to exceed the car loan settlement amount. That is, break even is reached when:

Market Value = Car Loan Settlement amount

If you sell your car before reaching the break even point, you will be making a loss. All the proceeds you will get from selling your car will be insufficient to pay off the debt.

In conclusion, a car loan may take a significant portion of your budget. It is therefore crucial to consider the long term impact a car loan will have on your finances. Before financing your car on debt, you need to protect yourself against further loss by having a gap cover. It is worthy pointing out that a car is not an asset, it is a liability except if the car is used for business.