Whether you’re a petrol head or an ordinary Joe, few things trump the smell of a new set of wheels.
While transport is a major consideration for most South Africans, you only have to take a quick glance at new vehicle advertising to realise that buying a car is about much more than getting from A to B. It is about aspiration.
Yet, even for high-income South Africans, affordability can be a concern. With the economy shedding jobs and pressure on disposable income, nowadays an affordable monthly car payment is even more of a priority than it may have been a few years ago. While one answer may be to settle for something cheaper or delaying the purchase while saving up, another option is to extend the finance period or opt for a balloon payment.
Over the past six years, most South Africans applying for vehicle finance chose a 72-month finance option – effectively paying their car over six years. More recently, it is not unheard of to be offered payment terms of 84 months (seven years) or even 96 months (eight years) – a decision that can reduce the monthly instalment significantly.
Although longer-term loans may address affordability concerns, it is also likely that when you trade-in the car three or four years down the line, its market value may not be enough to cover your outstanding car debt – leaving you out of pocket for the shortfall. The longer you extend the term of your loan, the longer it will take to reach a break-even position (where the outstanding debt equals the trade-in value of the vehicle).
An example demonstrates this clearly: Let’s assume you buy a new vehicle for R250 000 and borrow the full amount (100% loan). At an interest rate of 12.5% and a finance period of 72 months, the monthly payment will be around R4 950. If the period is extended to 96 months, the monthly instalment drops to around R4 130 (R820 less). The average car ownership period in South Africa is around four years, at which point the customer will still owe R100 830 on a 72-month loan, compared to R152 950 if the car was financed over 96 months. At this point, a buyer who financed the car over 96 months may find that the trade-in value is less than the outstanding loan amount and may be unable to settle their current loan when they attempt to trade their car in for another vehicle.
So where does that leave car buyers? Is a longer-term loan (beyond 72 months) the way to go or not? Let’s consider the pros and cons.
Since these longer-term loans address affordability concerns, they alleviate cash flow pressure and can help buyers to enter the market even on a tight budget.
With lower monthly payments, a buyer may also qualify for a larger loan, allowing them to finance a more expensive car.
As mentioned earlier, the most significant drawback of a longer-term loan is the risk that the outstanding credit may exceed the market value at the point you want to trade in the vehicle, leaving you out of pocket for the difference.
You will pay more interest over the period of the loan (all else being equal). Because the outstanding loan amount falls at a reduced pace, the capital amount on which interest payments will be calculated will be higher at the same point in time (for example, 10% on R100 000 is more than 10% on R95 000).
The repair costs may also become a headache. Most warranties cover 100 000 km or three years. If you finance a vehicle over 96 months, it is more likely that you will have to cover repair costs from your own pocket after the warranty runs out.
We also find that default rates increase where customers finance their vehicles over longer periods of time, which negatively affect their credit score.
We encourage customers to finance vehicles over shorter periods. As such, we prefer not to offer customers a finance term beyond 72 months when they apply for a car loan.
While affordability is an important consideration, we firmly believe that buyers – first-time buyers and buyers in the volume market in particular – should finance a vehicle over 72 months or less.
It is also important to consider the impact of the balloon payment (inflated final instalment). Financing a R250 000 vehicle over 72 months with a 30% balloon payment (12.5% interest, no deposit) will reduce the monthly instalment from around R4 950 to roughly R4 250, but will result in you paying much more interest over the six-year period.
By choosing something practical that suits your needs and paying it off as quickly as possible, you can save a lot of money over time, particularly during these difficult economic conditions we are facing as a country.
This approach can have a significant impact on your overall financial health and will stand first-time buyers in particular in good stead in the long run.
Faisel Mkhize is the Managing Executive for Vehicle and Asset Finance, Retail and Business Bank, Absa Group.
The views and opinions shared in this article belong to their author, cannot be construed as financial advice, and do not necessarily mirror the views and opinions of Moneyweb.