We all have a dream car. It could be a high-end sports car or a fully loaded pickup truck. Usually (and regretfully) our dream cars are out of our price range. Now image you're at the dealership talking to Bill, the sales guy, and you casually bring up your dream car. All of a sudden, Bill lets you know this car can be a reality, and all you have to do is agree to an 84-month loan. His finance office would be happy to accommodate. This will lower your monthly payments and you can squeeze that dream car right into your budget.
Tempting? Sure. But before you sign your life away, you need to look at the overall cost of the car loan and consider the risks involved.
What is a Long-Term Car Loan?
When you finance a vehicle, the available car loan terms come in increments of 12 months and usually range anywhere from 2 to 8 years. Anything over 5 years (or 60 months) is considered a long-term car loan and these stretched out loans are becoming more and more common. Not only are car shoppers staying in debt longer, they are borrowing more than ever before. 72% of new car loans have terms of over 5 years and the average new car loan amount is a staggering $30,000.
As you probably know, borrowing money isn't free. When a loan is stretched out to 72 or 84 months, the interest rates will typically shoot up. Interest rates usually increase for loans over 60 months and may even double. For example, instead of paying 3.2 percent interest on a 3 or 4-year car loan, you’ll be paying 6.4 percent on a seven-year car loan.
To illustrate the impact of stretching out the loan, we compared the total cost of a 7-year, long-term car loan with that of a 4-year loan. We took a $30,000 auto loan and looked at what the total cost would be for someone with fair credit for 4 years and 7 years. By going with the longer loan, the borrower gets a higher interest rate and ends up paying nearly $4,000 more than they would have with the shorter term loan.
Why Long-Term is Risky
A loan term of more than 5 years may give you a more comfortable monthly payment but there are serious drawbacks. The biggest concern you will run into is that cars depreciate quickly. According to Carfax, a new car will lose 60 percent of its total value over the first five years. This means you are at a higher risk of becoming upside down on the loan.
Upside Down Car Loan
Being upside on a car loan means you owe more on the car than it's worth. Even if you don't think you'll sell your car for a long time, being upside down on a loan is a dangerous game. If you lose your source of income or experience a sudden change in your finances and can't make payments, you may fall into a negative equity cycle.
Negative Equity Cycle
If you do need to trade-in your car before your loan is paid off and you're upside down, you may be able to do so, but you'll also risk falling into a negative equity cycle that's difficult to dig yourself out from. According to Forbes, many car dealers will take your trade-in, even if you owe more than it's worth. They're able to do this is by taking the amount you're underwater for your current car and applying it to the balance of your new car loan. As you can imagine, this situation can spiral out of control as it puts you in more debt than you were in before.
What You Should Do
If you don't want to throw yourself into a cycle of debt, you need to do the math prior to looking for cars to determine a comfortable monthly car payment for your budget. Don't tempt yourself by looking at cars that will make you stretch your budget. From here, you should look at the overall price of the car loan including the interest and compare loan terms using a car loan calculator. You can find one on our car loans resource page. Here are some other practical tips.
Don't Negotiate on Monthly Payments
Going back to our example with
Buy Less Car or Buy Used
Instead of stretching out a loan to 6, 7 or even 8 years, consider going with a less expensive vehicle or buying used instead of new. When you buy a used car, in addition to being able to go with a shorter loan and lower interest, you'll also bypass the instant depreciation once you drive off the lot.
Take the Shortest Loan Term
Going with the shortest possible loan term (under 5 years) and accepting the lowest interest rates will help with paying your car off without going upside down on the loan. Although you may have to make some sacrifices in the short term such as a higher monthly payment or buying a less expensive car, you'll be saving money and avoiding a cycle of debt in the long run.