Long-term auto loans are the new normal. The credit monitoring experts at Experian report that average car loan terms are getting longer every year[1]. Ten or twenty years ago car loan terms were rarely more than four to five years. Today’s loan terms are routinely as long as seven or eight years.
A long-term loan can keep your monthly payment down and might seem to make that dream car more affordable. That doesn’t always make it a good deal. Let’s take a look at long-term auto loans and how they can affect your finances.
The Rise Of Long Term Auto Loans
According to the recent Experian State of the Auto Finance Market report[1] (3rd quarter of 2020), over 80% of those who purchased vehicles that quarter used some type of financing. The average auto loan term among all but the Super Prime buyer category (those with the highest credit scores) increased to over 70 months. Nearly 30% of buyers took on loan terms from 73-84 months. A small percentage of borrowers (just over 1%) took on car loans with terms of 85 months or longer.
🤔 What is driving consumers to take on auto loans that have terms of seven, eight, and nine years? The short answer is “money”.
Why Have Long Term Auto Loans Become So Popular?
It’s a bit of a paradox, actually.
- Consumers choose longer term auto loans primarily so they can have more affordable payments.
- Lenders are happy with that because longer loan terms mean higher interest and more profit for them.
- Dealerships are happy because they can sell more expensive cars.
Which group is really coming out ahead financially in this partnership?
👉 Example:
If you’re taking on a $60,000 auto loan for 60 months with an average loan interest rate of 4.22% (the average rate according to the Experian report), your monthly payment will be roughly $1,110 per month.
If you stretch that loan out to 84 months your payment drops by nearly $300 each month to roughly $826.
A $300 per month drop on a loan payment can be a make or break deal for many car buyers.
Long term auto loans have perceived benefits to both the auto industry and to consumers.
The auto industry sees long term auto loans as a way to encourage consumers to buy a more expensive vehicle than they might with a shorter term loan. That means more money in the pockets of car dealers and financing companies.
Consumers see long term auto loans as a way to have a newer vehicle or a vehicle with more features than they might otherwise be able to afford.
🧐 A Brief History Of Auto Loans
It wasn’t that way decades ago. Benjamin Franklin said in the 1700’s that one should “Rather go to bed without dinner than to rise in debt.”
Borrowing money was the exception rather than the rule in the early years of America. The auto industry was one of the first to see how easier access to credit could drive higher sales. The Ford Motor Company issued the first auto loan in 1908. GM followed suit in 1919. Unlike the long term, zero down auto loans of today, early auto loans came with strict stipulations[2]. They required down payments of 35 percent or more, and 12 months was the maximum term.
The early auto loan lenders were committed to recouping their loan proceeds quickly. The goal? Get the money back before car owners started spending their cash on car repairs.
This is a far cry from the attitude of today’s lenders. Instead of recouping loan funds quickly, auto loan lenders shell out loans and quote interest rates strictly on a gamble. They bet on your eagerness to buy a nicer car and your willingness to repay the loan in full.
That “gamble” mentality has led lenders and borrowers to partner together to loosen the purse strings of consumers on the bet that they both get what they want: Lenders hope for larger profits and borrowers hope for nicer cars. They take out longer and longer term loans with little thought of paying those loans off early. This partnership brings significant risks for borrowers.
Financial Implications Of Long Term Auto Loans
Long term auto loans make fancier cars seem more affordable, but that appeal comes with some drawbacks. Let’s look at some of them.
Car Values Drop Faster Than Loan Balances
Cars depreciate fast. The average automobile loses 7% of its value the moment it leaves the dealership, close to 20% of its value in the first year you own it, and 60% of its value in the first 5 years[3].
If you take on a long term car loan, especially with no down payment or low down payment, you will almost certainly owe more than your car is worth for much of the loan’s lifetime. This is called having negative equity, being underwater, or being upside down on your car loan, and it has potentially serious consequences.
- Theft or accident can be a big problem. If your car is stolen or wrecked, your insurance will only pay the value of the car. You may have to take on additional insurance or face the possibility of having to cover the balance of the loan yourself in a worst-case scenario.
- If you want to sell your car you’ll have to add money to pay off the loan balance.
- If you trade your car in on a new one the difference between the car’s value and the loan balance will be rolled into your new loan, making the new car even more expensive.
You may never notice being underwater on your car loan, except for the cost of the extra insurance that you may choose to buy.
⚠️ If your car is wrecked or stolen, or if you need to sell it, being underwater can suddenly become a serious problem.
💡 If you are already in this situation, here are some tips and strategies for getting out of an upside down car loan.
You’re Paying More In Interest
Long term auto loans cost you more. Let’s revisit the $60,000 car loan we talked about above.
👉 Example:
At an interest rate of 4.22% on a 60-month loan, you’d pay a total interest of $6,657.49 for that $60,000 vehicle.
If you took out the 84-month loan, your interest payments total just over $9,400.00.
You’re paying nearly $3,000 more for that vehicle than you would have had you stuck with the 60-month loan.
If you took that $3,000 and invested it at an annual ROI of 5%, you’d have over $4,000 after that seven years. That’s a big difference.
Your Auto Loan Will Outlast The Car’s Warranty
Most new cars come with a three-year “bumper to bumper warranty” covering most of the car’s systems. The engine and transmission will be covered by a longer powertrain warranty. If you take out a long-term car loan there’s a good chance that your warranty will expire long before your loan is paid. Your car may need significant repairs before the loan is paid.
⚠️That means you could end up paying both your loan payment and payments for expensive repairs at some point. That scenario could be quite taxing on your pocketbook.
You May Be Tempted to Buy More Car Than You Can Afford
Long-term car loans are a great tool for salespeople. If they see a customer ogling an expensive sports car, luxury sedan, or SUV, they can make an offer. They’ll pitch a monthly payment that can make that dream car sound much more affordable than it really is.
Any time a salesperson quotes a monthly payment instead of a total price, stop and think. Take a close look at what’s not being said. Calculate the total cost of what you’re getting into and ask yourself whether you need it and whether you can afford it. It’s fun to drive a nice car, but it’s also fun to have money in your pocket.
➗ Our Auto Loan Calculator will help you estimate your monthly payment and the total costs of your loan.
Alternatives To Long Term Auto Loans
A long term loan is probably not your only option. Here are some suggestions to consider.
Buy An Older Car And Pay Cash
I started paying cash for cars about five years ago and haven’t looked back. Paying cash means I have to buy older cars, but it’s worth it, at least for me. The financial nerd in me enjoys a bit of a high when I hand over a wad of cash for a car purchase and drive away free of the burden of car payments.
It can take some extra time to find “the one” when you are shopping for quality older used cars. With the right research and the right connections, you can attract sellers who take excellent care of their cars, own them for several years and then sell and get a new one.
Imagine the money you can save each month if you don’t have a car payment. Imagine what you could do with that money: pay off credit card balances or student loan debt, build an emergency fund, save for a down payment on a home, and so much more.
Purchase A Less Expensive Car
You also have the option of purchasing a less expensive car; one that will provide you with affordable payments and a shorter term loan. Many car experts advise not taking on any loan longer than 60 months[4]. That means choosing a car that provides affordable payments on a 60 month term.
☝️ You may not be able to get your “dream” car with this strategy, but spending less money could leave you with more financial security. You may find that an entry-level or used car is completely adequate for your needs.
Lease A Car
If you really need a car with a bit of bling (for example, if your job requires entertaining high-end clients) there’s always the option to lease.
Leasing is often frowned upon for many reasons (it’s basically akin to renting and you can pay huge out-of-pocket costs if you go over mileage limits), but it can be a good alternative to carrying a car loan for seven or eight years, holding negative equity, and racking up huge interest payments.
Are long term auto loans worth it? The choice is yours, of course. But in the name of financial security and peace of mind, it’s wise to at least consider the alternatives and avoid long term auto loans if you can. It may be tempting to get grab your dream car at an affordable monthly payment, but it’s usually not a good idea from a financial perspective.
