The Pitfalls of Taking Out a Really Long Car Loan
When selecting vehicles and loan terms, most consumers focus on monthly payments. It seems like a simple way to make sure the car and financing fit their budget. But it can be a costly mistake.
Over the last 10 years, as vehicle prices rose, dealers pushed buyers into signing up for lengthier auto loan terms to reduce their monthly payments. The market for longer term financing (six years or more) has grown dramatically. Right now, the average new car buyer is financing about $34,000 and taking out a loan of 68 months, according to Bankrate.com.
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“That’s too long,” said Jack Gillis, executive director of the Consumer Federation of America (CFA) and author of The Car Book. “If you’re forced to take out a loan that’s six, seven, or even eight years, that probably means you’re buying more car than you can afford.”
“While longer loan terms may make monthly payments more affordable, it is not clear that consumers are better off taking out longer-term loans or that they will be more likely to successfully repay the loan,” a report issued by the Consumer Protection Financial Bureau (CFPB) in 2017 concluded.
The CFPB found that longer-term loans are related to both the dollar amount being financed and the borrower’s credit. The average amount financed with a five-year loan was $20,100, compared to $25,300 for a six-year loan, and $32,000 for loans of seven years or more. It also found that borrowers who took out loans of six years or longer had “notably lower” credit scores than those who opted for five-year loans, and the default rates were higher.
Why You Should Avoid Long-Term Vehicle Loans
Taking out a lengthy auto loan produces several pitfalls:
You’ll pay more in interest.
Long-term loans appeal to buyers who need monthly payments that fit their budget, or who want to buy more car than they can otherwise afford. While a loan that runs seven or eight years may get you behind the wheel, it will drive up the overall cost of that vehicle. Do the math: The longer the loan, the more interest you’ll pay.
Philip Reed, automotive editor at NerdWallet, said taking out a car loan longer than 60 months is a big mistake.
“A lot of people don't really pay attention to interest they’re paying; they just worry about the monthly payment,” Reed said. “Pull out a calculator and run the numbers, and you’ll see that a longer loan could cost you thousands of dollars more.”
If you have a good credit score and can get an ultra-low interest rate, this isn’t as much of a problem. But for those with poor or fair credit, it’s very costly.
For example, a buyer with poor-to-fair credit (a score of 601-660) who finances a $34,000 loan at 6.65 percent APR would pay $6,058 in interest over the course of a 60-month loan, $7,326 over a 74-month loan, and $8,618 over an 82-month loan.
You’ll be upside-down longer.
A longer loan will reduce your monthly payments, but it won’t slow down the rate of depreciation for your new wheels. So, you end up being “upside-down”—owing more on the vehicle than it’s worth—for longer.
“Being upside down is a problem if you get tired of the vehicle and want to trade it in, or if it gets stolen, or totaled, in an accident,” said Greg McBride, chief financial analyst at Bankrate.com. “If you owe more than it's worth, you won’t get enough if you sell it or receive an insurance settlement to pay off the loan balance. That means you will have to come up with the difference. You could be on the hook for thousands of dollars.”
Combining a low downpayment with a longer loan only compounds the problem, since it takes even longer to build up substantial equity.
“In the first year a car will lose roughly 20 percent of its value,” said Ron Montoya, senior consumer advice editor at Edmunds.com. “So, if you haven’t put down at least that much, you’re already upside-down, and owe more on the loan than the car is worth.”
Drivers with long loan terms often end up in cycle of debt.
Many consumers love their cars when they’re new, but less so after several years when faced with higher maintenance bills, or they simply get tired of what they’re driving.
Ask yourself: If I have a seven-year loan, and I decide to ditch the car after six years, for whatever reason, can I come up with enough money to pay off the balance? Many drivers can’t, but need or want a new ride; they often opt to roll the unpaid loan balances from their old cars into new loans, creating an ever-increasing cycle of debt.
Dealers are happy to roll over their customers’ debt into new loans, but as Montoya points out, “you now have a loan that’s more than that new vehicle is actually worth.”
How to Avoid Loan Pitfalls
CFA’s Gillis recommends a loan that’s four years or less. “That way, you’ll reduce your interest costs, you won’t be upside-down in the car, and if you have to sell, you’ll be OK,” he said.
In that case, wait until you can save enough to make a bigger downpayment and get a shorter loan, or find a less expensive vehicle. Here are three ways to do that:
- Choose a lower trim level that would fit your budget. For example, the MSRP for Subaru’s top-of-the-line Outback Touring XT is $39,945. The base model Outback doesn’t have ventilated seats and power folding mirrors, but it’s about $13,000 less ($26,975).
- Is there a corporate twin with a lower price? Manufacturers often make two or three versions of the same car under different brand names with different price tags. For example, the Ford Expedition is “essentially the same mechanically” as the Lincoln Navigator, but you’ll pay as much as $7,000 more for the Navigator because of the branding, Gillis said.
- Think used. Maybe you can find a used version of the vehicle you want—let the previous owner eat the depreciation. You pay less and start building equity much faster. In many cases, used vehicles less than three years old are still covered by manufacturer warranties.
You’ll also lower costs by shopping around for the best loan deal. When you take out a loan, you’re really buying credit, so you need to comparison shop to find the best price.
Although interest rates for many buyers are currently low, serious money is still at stake. Total payments for a 48-month $30,000 loan, for example, are $1,273 higher with a four-percent interest rate than a two-percent rate.
Check the annual percentage rate (APR) currently offered by banks and credit unions in your area. Several institutions offer auto loans nationally. Use sites like Bankrate.com to identify lenders and look at bank rates.
If you’re ready to buy, get preapproved for a loan. This requires a credit check, but by obtaining preapproval on your own you simplify the buying process by taking financing considerations off the bargaining table, leaving only the vehicle purchase price to discuss.
Of course, the dealer might offer you a better rate than what you secured on your own. Manufacturers often provide below-market rates to attract customers. Just be aware that very few buyers—only those with the highest credit scores—qualify for advertised zero percent or ultra-low interest rates.
Most car purchases involve three business deals: price of the new vehicle; selling or trading in an old one; and financing. “It's very important to keep those three transactions separate,” Gillis advised. “That way, you know exactly what you're paying for the new car, what you’re getting for the old car, and how much you’re paying to finance the purchase.”