Car Loans: Long-term car loan is a bad idea?

Long-term car loan is a bad idea

Americans are taking on car loans longer than six years more than in the past, according to Experian Automotive, and that's not the wisest financial choice for many people.

According to the latest Experian research, new-car loans that are longer than six years now represent 16.9 percent of all new-car loans, a 19.4 percent increase over last year. On the used-car side, 10.1 percent of all used-car loans are longer than six years -- an 11.5 percent increase over 2012.

Longer-term car loans are attractive because monthly payments are smaller than on a shorter-term car loan. And, because they allow a car buyer to buy a more expensive car while still making the payment affordable, they can actually make things worse financially.

When it comes to buying a new car, the longer the car loan, the longer the owner will be " upside-down" in the loan -- where he owes more than the car is worth -- unless there's been a significant down payment. This is because a larger portion of the monthly payments early on in the loan is going toward interest. Being upside-down is dangerous, because if the car owner has a car accident where the car is considered a total loss, he could end up still having to pay off a loan on a car that he can no longer drive.

In addition, the longer an owner is upside-down in the car loan, the harder it is to have equity in the car, which means that when it is traded in, it may not count for much of a down payment on another car.

Finally, the longer the car loan, the more interest will be paid over the life of the loan, making the car cost more than a shorter car loan in the long run.

Even though depreciation is less of an issue with used cars, since a car depreciates the most in its first few years, long-term car loans on used cars aren't a good idea, either. A used car already has a significant number of miles on it and a longer-term car loan would mean that the car will have higher mileage when it is finally paid off.

For example, assume that you buy a 3-year-old car with 36,000 miles on it, which is what the average American would drive in that length of time. If you take out a six-year loan and you drive 12,000 miles annually, the average in America, you would add 72,000 miles. This would mean your car would have 108,000 miles on it and would be approaching 10 years old by the time it's paid off. If you choose to trade it in sooner, you may find it's not worth much, or worse, that you have no equity at all.

While the lower monthly payment on a long-term car loan may be appealing at first, it is better for most car buyers to save up some additional cash to increase the down payment or to select a less expensive car so the monthly payment is affordable for a loan that is shorter.
By Tara Baukus Mello /  Bankrate.com

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Are Longer Terms a Bad Thing?

Any time you drive a really cool car, it’s inevitable that you’ll end up on the manufacturer’s website, configuring your ideal version of that car. As soon as you finish, you’ll look at the total price, laugh at the thought of spending that much money on a car, and then go back to trying to convince yourself that your current transportation situation is fine just the way it is.

After driving the Fiat 500 Abarth, I did exactly that as soon as I got home. Conveniently, Fiat includes a payment estimator with its configurator, but instead of quoting an absurdly high number like I expected, it told me I could buy the convertible version for $369 per month. My first thought was, “Oh no, I could actually afford to buy this car.”

Then I looked at the loan term it was using to calculate my payment. The reason my estimated payment was so low was because I’d have to pay that $369 for 72 months. In 72 months, I’ll be 32 and will have just celebrated my five-year wedding anniversary. Heck, I could even be a father by then. That’s much too far in the future to still be paying for a car.

Not long ago, the idea of taking out a 72-month car loan would have been absurd. Whether it is or not, it’s certainly not unheard of anymore. As Detroit News reports, the average car loan term is now 67 months for new cars and 62 months for used cars. Even worse, longer-than-normal terms of 73 to 84 months made up just barely under 30% of all vehicles financed in the first quarter of 2015.

The amount of money that customers are financing has gone up as well. In the first quarter of 2014, it was $27,612, but in 2015, it rose to $28,711. As a result, average monthly payments are now up from $474 to $485.

Longer terms on larger loans with higher payments have the potential to be a problem if more people end up defaulting on their loans, but there are definitely advantages to longer loan terms.

It’s normal for car prices to increase with inflation, and considering the advancements in technology over the last several years, no one should be surprised by that. The current Hyundai Sonata, for example, is so much better than it was in 2009, it’s easy to see why the new version costs more money. Unfortunately, with wages generally stagnant, the only way a lot of people can afford a new car is to take out a longer loan.

For some households, the problem isn’t necessarily that the monthly payment on a 36 month loan is too high. Instead, they’re worried that the larger payment will be cutting it too close every month. Being able to save several hundred dollars per month may make it worth paying more in the long run if it means having the cash on hand to cover unexpected costs such as medical bills. Paying $30,000 for a $24,000 car isn’t great, but credit card interest is much higher than car loan interest, which could end up being hugely beneficial in the long run.

Finally, even people who can afford to make higher payments are taking advantage of longer loan terms and low interest rates. If their investments are earning more interest than they are paying on a car loan, it only makes sense to leave that money invested instead of taking the shorter term.

The key to all of this, however, is to actually keep the car at least for the entire lease term. Most modern cars are just getting started at 100,000 miles, so keeping one for seven years is not a big deal, at least mechanically speaking. If someone does sell their car early, though, they’re almost guaranteed to owe more than it’s worth. That will mean either buying a lower quality car to replace the one that was just sold or rolling their remaining balance into their next car loan, putting them underwater the second they drive off the lot.

Melinda Zabritski, senior director of Experian Automotive, agrees, saying that “while longer term loans are growing, they do not necessarily represent an ominous sign for the market. It is critical for consumers to understand that if they take a long-term loan, they need to keep the car longer or could face negative equity should they chose to trade it in after only a few years.”

Longer loan terms might not necessarily represent impending doom and gloom, but buyers should definitely be cautious when taking out car loans, especially ones longer than 72 months. There are certainly benefits to longer loan terms, but there are also risks that should be seriously considered before signing up to pay for a new car over the next five to seven years.

By Collin Woodard / www.cheatsheet

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