4 big risks of taking out a long-term car loan
By Nick Clément, Next avenue Donor
(Clements also contributes to Forbes. His posts can be found here.)
Auto loans have become bigger, longer and riskier. If you are considering taking out a car loan for five years or more, you might want to think about it again.
Based on data from Experiential, average auto loan amounts hit an all-time high. For new cars, the typical loan is now over $ 30,000 and the average used car loan is $ 19,329. Particularly worrying: borrowers stay in debt longer. Today, 72% of new car loans and 59% of used car loans have a term of more than five years.
Why are people willing to take such big loans for so long?
Rational and less rational reasons for long-term auto loans
There is a rational explanation: average age of cars, SUVs and vans has climbed to 11.6 years, which means people are keeping their vehicles longer than in the past.
But there is also a less rational reason: People are going for more expensive cars at the dealership. At the dealership, car buyers tend to focus more on the monthly payment than the full cost of financing. So savvy car sellers can use longer term loans to lower monthly payments, increasing their chances of selling a more expensive car for a larger commission.
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Before you walk out of the showroom with a long-term auto loan, be sure to consider the four big risks first:
Risk # 1: you could end up underwater
An automobile is a depreciating asset. According to the self-shopping research firm Edmunds, a new car loses 11% of its value when it leaves the lot. During the first five years, the car will lose up to 25% of its value each year. Unfortunately, your loan will not be repaid as quickly as the vehicle depreciates.
In the first year of a seven-year loan, only 12% of the loan balance will be repaid. The actual amortization occurs in the later years of the loan.
If you want or have to sell your car early in its life, you may owe more than the car’s value, ie the car will be “under water”.
This can be particularly troublesome if your income has gone down or if you have lost your job. In such cases, you don’t want to end up with a loan balance that is more than the value of your car.
Risk # 2: You may find yourself trapped in an accelerating negative cycle of actions
Auto dealers understand that more and more borrowers are under water due to long-term loans. Thus, at the time of trade-in, many auto lenders are now willing to provide loans to these customers to cover the shortfall of their previous vehicles.
Imagine that the value of your car has gone down to $ 20,000, but your loan balance is $ 25,000. Some auto lenders will add the $ 5,000 shortfall to your new auto loan balance, which will put you even deeper underwater on your next vehicle.
Short-term financing ensures that borrowers end up with balances much higher than the value of their automobiles. But you can only play this game for such a long time.
Risk # 3: Do you really want to keep your car for 7 years?
While automobiles, in general, last longer than in the past, you might not want to hang on to yours for many years. For example, a larger vehicle may come in handy when you need multiple car seats for the grandchildren. But as you get older, you might be ready to move on to something smaller. Why have a loan that lasts longer than the length of time you plan to own the car?
Risk # 4: you end up paying a lot more for your car
If you finance a car for $ 30,000 over five years at 6%, you will end up paying $ 34,799 over the life of the loan. If you borrow for seven years, you’ll end up paying $ 36,813 for that $ 30,000 car. By adding two years to the term of the loan, you will increase its cost by 7%.
It’s not great for anyone of any age, but it’s especially unwise for retired people; it’s best to keep your debt to a minimum as a retiree without a full-time paycheck to cover payments. So if you’re retired, or soon will be, focus on the full cost of the vehicle (which will need to come from retirement savings) rather than just the monthly payments.
Does a long term auto loan make sense?
Yes he can. If you have great credit, the car maker might give you a special deal with an interest rate close to 0%. In this case, if you can borrow for seven years at 0%, it might be a good idea to take out the loan. Then invest the money that you would otherwise have used to buy the car.
There are also other lenders, including some credit unions, who now offer very low rates for borrowers with excellent credit. For example, LightStream (a division of SunTrust) offers two- and three-year auto loans with rates as low as 2.19% and PenFed Credit Union offers three-year loans on new cars as low as 1.49% .
However, if you don’t have a good credit rating, auto loans can get very expensive. Subprime auto loans often have interest rates of 14% or more. In these cases, keeping your loan shorter – even if that means buying a cheaper car – is probably the best way to go.