Money & Policy

4 Big Risks of Taking Out a Long-Term Car Loan

The monthly payment may be low, but the overall cost may be high

Auto loans have been getting bigger, longer and riskier. If you’re thinking about taking out a car loan of five years or longer, you may want to think again.

According to data from Experian, average car loan amounts are at a record high. For new cars, the typical loan is now above $30,000 and the average used car loan is $19,329. Particularly worrisome: borrowers are staying in debt longer. These days, 72 percent of new car loans and 59 percent of used car loans have terms of more than five years.

Why are people willing to take out such big loans for so long?

By adding two years to the term of a five-year loan for a $30,000 car, you will be increasing the auto's cost by 7 percent.

Rational and Less Rational Reasons for Long-Term Car Loans

There is one rational explanation: The average age of cars, SUV and pickups has climbed to a stunning 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 getting talked into more expensive cars at the dealership. At the dealership, car buyers tend to focus more on the monthly payment than the total cost of financing. So savvy car salesmen can use longer-term loans to keep monthly payments lower, increasing the chance of their selling a more expensive automobile for a larger commission.

Before driving out of the showroom with a long-term auto loan, be sure you first consider the four big risks:

Risk No. 1: You Could Wind Up Under Water

An automobile is a depreciating asset. According to the auto-shopping research firm Edmunds, a new car loses 11 percent of its value the moment it leaves the lot. During the first five years, the car will lose up to 25 percent of its value every year. Unfortunately, your loan will not get paid down as quickly as the vehicle depreciates.

During the first year of a seven-year loan, only 12 percent of the loan balance will get paid. The real amortization happens in the last few years of the loan.

If you want or need to sell your car early in its life, you will run the risk of owing more than the car is worth — i.e. the car will be “under water.”

That can be especially troublesome if your income has fallen or you’ve lost your job. In cases like that, you don’t want to be stuck with a loan balance that’s higher than your car’s value.

Risk No. 2: You Can Get Trapped In A Negative Equity Cycle That Accelerates

Car dealers understand that more and more borrowers are under water due to long loans. So at the time of the trade-ins, many auto lenders are now willing to make loans to those customers to cover the shortfall on their previous vehicles.

Imagine your car has declined in value to $20,000, but your loan balance is $25,000. Some auto lenders will add the $5,000 trade-in shortfall to your new car-loan balance, which will put you even deeper under water on your next vehicle.

Shortfall financing ensures that borrowers end up with balances that are much higher than the value of their automobiles. But you can only play that game so long.

Risk No. 3: Do You Really Want To Keep Your Car 7 Years?

Although automobiles, in general, last longer than in the past, you may not want to hang onto yours for many years. For instance, a larger vehicle might be useful while you need multiple car seats for the grandchildren. But as they grow older, you may be ready to shift to something smaller. Why have a loan lasting longer than the length of time you plan to own the car?

Risk No. 4: You End Up Paying Much More For Your Car

If you finance a $30,000 car over five years at 6 percent, you will end up paying $34,799 over the term of the loan. If you borrow for seven years, you will end up paying $36,813 for that $30,000 auto. By adding two years to the term of the loan, you will be increasing its cost by 7 percent.

That’s not great for anyone of any age, but it’s especially unwise for people in retirement; it’s best to keep your debt load minimal as a retiree without a full-time paycheck to cover payments. So if you’re retired, or will be soon, focus on the total cost of the vehicle (that will need to come from retirement savings) rather than just monthly payments.

Does a Long Car Loan Ever Make Sense?

Yes, it can. If you have excellent credit, the automaker might offer a special deal with an interest rate close to 0 percent. In that case, if you can borrow for seven years at 0 percent, it could make sense to take out the loan. Then, invest the cash that you would’ve otherwise used to buy the car.

There are also other lenders, including some credit unions, now offering 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 percent and PenFed Credit Union has three-year loans on new cars as low as 1.49 percent.

If you do not have a great credit score, however, auto loans can get very expensive. Subprime auto loans often have interest rates of 14 percent or higher. In these instances, keeping your loan shorter — even if that means getting a less expensive car — is likely the best way to go.

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Nick Clements
By Nick Clements
Nick Clements is a former banker turned consumer advocate and co-founder of the personal finance and lending information site MagnifyMoney.com by Lending Tree.@npclements

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