You have your heart set on that hot new sport coupe with alloy wheels and a sunroof but the monthly payments just won’t fit in your budget. The salesman sighs sympathetically, and then says, “I have an idea of how to make this work.”
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He recommends a 72- or 84-month loan. The down payment remains the same but the payment’s a bit lower. As he talks, you begin to picture the coupe in your garage and showing it off to your friends.
But wait just a second! Cancel the daydreams. Long loan terms are setting you up for a “vicious cycle of negative equity,” says car buying concierge Oren Weintraub, president of AuthorityAuto.com.
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Alarming car buying statistics
Auto loans over 60 months are not the best way to finance a car. And yet, 43.5% of new-car buyers in the third quarter of 2015 took out loans of 61 to 72 months, according to Experian. More alarmingly, Experian data show 27.5% of car shoppers are signing loans for between 73 and 84 months — that’s from six to seven years, folks, and that category grew 17.1% from the previous year.
“To close the deal, [car dealers] need to offer a payment that is comfortable,” Weintraub says. “Instead of reducing the sale price of the car, they extend the loan.” However, he adds that most dealers probably don’t reveal how that can change the interest rate and create other long-term financial problems for the buyer.
Used-car financing is following a similar pattern, with potentially worse results. Experian reveals that 41.3% of used-car shoppers are taking 61- to 72-month loans while 16.2% go even longer, financing between 73 and 84 months. Again, that category is growing fast — up 12% over the previous year.
If you bought a 3-year-old car, and took out an 84-month loan, it would be 10 years old when the loan was finally paid off. Try to imagine how you’d feel making loan payments on a battered 10-year-old heap.
Long loan terms are yet another tool the dealer has to put you into a car because they focus you on the monthly payment, not the overall cost. But, just because you could qualify for these long loans, doesn’t mean you should take them.
5 reasons to buck the long-loan trend:
- You are “underwater” immediately. Underwater means you owe more to the bank than the car is worth. “Ideally, consumers should go for the shortest length auto loan that they can afford,” says Jesse Toprak, CEO of CarHub.com. “The shorter the loan length, the quicker the equity buildup in your car.” Equity in your car means you aren’t drowning in debt and could trade it in or sell it at any time and pocket some cash.
- It sets you up for a negative equity cycle. Say you have to trade in the car before a 72-month loan is paid off. Even after giving you credit for the value of the trade-in, you could still owe, for example, $4,000. “A dealer will find a way to bury that four grand in the next loan,” Weintraub says. “And then that money could even be rolled into the next loan after that.” Each time, the loan gets larger and your debt increases.
- Interest rates jump over 60 months. Consumers pay higher interest rates when they stretch loan lengths over 60 months, according to Edmunds analyst Jeremy Acevedo. Not only that, but Edmunds data from this April show that when consumers agree to a longer loan they apparently decide to borrow more money, indicating that they are buying a more expensive car, including extras like warranties or other products, or simply paying more for the same car. When financing with term lengths from 61 to 66 months, the average amount financed was $27,615 and the interest rate was 2.8%, bringing the monthly payment to $462. But when a car buyer agrees to stretch the loan to 67 to 72 months, the average amount financed was $30,001 and the interest rate more than doubled to 6.4%. This gave the buyer a monthly payment of $500.
- You’ll be shelling out for repairs and loan payments. A 6- or 7-year-old car will likely have over 75,000 miles on it. A car this old will definitely need tires, brakes and other expensive maintenance — let alone unexpected repairs. Can you meet the $500 average loan payment cited by Edmunds, and pay for the car’s upkeep? If you bought an extended warranty, that would push the monthly payment higher.
- Look at all the extra interest you’ll pay. Interest is money down the drain. It isn’t even tax deductible. So take a long hard look at what extending the loan costs you. Plugging Edmunds’ averages into an auto loan calculator, a person financing the $27,615 car at 2.8% for 60 months will pay a total of $2,010 in interest. The person who moves up to a $30,001 car and finances for 72 months at the average of 6.4% pays triple the interest, a whopping $6,207.
So what’s a car buyer to do? There are ways to get the car you want and finance it responsibly.
4 strategies to turn the tables on long loans:
- Lease instead of buy. If you really want that sport coupe, and can’t afford to buy it, you can probably lease for less money upfront and lower monthly payments. This is an option Weintraub will suggest to his clients, especially since leasing deals are so aggressive right now, he says. If you want the car at the end of the lease, you have the right to buy it at the current market value.
- Use low APRs to increase cash flow for investing. CarHub’s Toprak says the only time to take a long loan is when you can get it at a very low APR. For example, Toyota offers 72-month loans on some models at 0.9%. So instead of tying up your money by making a large down payment on a 60-month loan, and making high monthly payments, use the money you free up for investments, which could yield a higher return.
- Refinance your bad loan. If your emotions take over, and you sign a 72-month loan for that sport coupe, all’s not lost. Assuming your credit is good, you may be able to refinance your auto loan at better terms without an early payment penalty or fees.
- Make a large down payment to prepay the depreciation. If you do decide to take out a long loan, you can avoid being underwater by making a large down payment. If you do that, you can trade out of the car without having to roll negative equity into the next loan.
Making the right auto loan decision will help you and your family enjoy a stress-free life and prepare for the future. To review the basics of car financing, take a look at How Much Should My Car Down Payment Be?
Philip Reed is a staff writer at NerdWallet, a personal finance website. Email: firstname.lastname@example.org.