Auto loan terms are getting longer, the current average is over five years. Some people are opting for long terms loans: 84 months – or 7 years. But there are risks to this.
If you have been shopping for a car, you may have noticed that the costs of new vehicles are going way up. According to the analysts at Kelley Blue Book, the estimated average transaction price for new passenger vehicles in the US in October 2019 was $37,590.
These higher costs are due to many factors:
Here’s an easy but costly solution to high costs: longer loan terms!
As vehicle costs go higher, the cost of financing your purchase increases. This applies to both the principal and the interest. As a way to keep your monthly payments affordable, loan terms on vehicles have been stretching out longer than the traditional five-year term. There are now car loans that can go as long as six years, seven years, sometimes even eight years! The average down payment has also gotten smaller, in an attempt to keep the whole transaction affordable to the customer. Even though the interest rates are higher on longer-term loans, the payments seem to fit your budget. This sounds like a great idea that makes perfect sense, doesn’t it?
You put the deal together in the showroom and drive off in your shiny new vehicle. You firmly believe that this is an excellent way to buy a vehicle. You will have six to eight wonderful years of ownership, and after it’s paid off you’ll figure out the next step. What could possibly go wrong?
Just about everything!
The typical long-term car loan would not be such a large problem – if people actually kept their cars until the last payment was made. Unfortunately, many owners don’t do this, for a wide variety of different reasons, including:
So off you go, shopping for a new car, with maybe half of the loan paid on the old one. You are about to be in for a big shock!
The brutal reality of depreciation
Vehicle depreciation is a terrible thing during the first few years of a long-term loan. It causes the value of your vehicle to drop very quickly once you drive it off the lot, and it continues to work against you during those early years of ownership. Back when most loan terms were shorter, this wasn’t so bad – you were making larger payments relative to the car’s value, so you could better keep up with the rate of depreciation. But with a long-term loan, the car is depreciating much faster than you are paying off the loan. As a result, you owe much more on your loan than the vehicle is worth on a trade. That’s not good for you!
Now you are underwater
Your situation at this point is called negative equity, which is also known as being “underwater.” Negative equity is a deep, dark hole of extra debt. If you buy a new vehicle now, you will have to deal with that added debt, as you make the deal on your new car. Your negative equity could be as much as several thousand dollars – and you will need to cover it before you can drive off in your new car. This is comparable to a gambling debt that you must pay off before you can continue playing the game.
What usually happens in this situation? Without enough cash on hand to pay off the negative equity on the old loan, the dealer will be only too happy to “roll” the amount you are “underwater” into the loan on your new car. You end up in even more debt for a longer term, and the sad cycle starts all over.
You can drown financially from being underwater like this
Now you have a serious problem. No matter how long you own the new car, it will never be worth anything near the amount owed on the loan. Your hole of negative equity is now much deeper. It may even be too deep to climb out of. If you try to do this again, with another car and another loan, it may not work. You may find that either you can’t afford the monthly payments, or you can’t get approved for what is now a huge loan – without providing a large down payment that you don’t have. You have reached the end of the line.
How to avoid the dangers of long-term car loans
If you value your financial health, and you want to keep it in good standing for many years to come, here are some strategies for avoiding the dark side of long-term automotive debt:
Buy a less expensive car: If you can’t work a deal that keeps your loan term at five years or less, consider going down a size class. Instead of a mid-size car, get a compact. You will save thousands of dollars, and still get a well-equipped vehicle. Another option is to get a lower trim level with less standard equipment. If you can live without leather seats and a sunroof, you will end up with much less debt.
Make a larger down payment: If you can save up some money and put a few thousand dollars down, you can probably afford the payments on a shorter-term car loan. This will also help to keep you out of the negative equity zone, since you are financing a smaller percentage of the new car’s value.
Seek out manufacturers’ deals: Certain models receive incentives from their manufacturers at various times. Check the vehicle manufacturers’ websites under “Special Offers.” A cash back rebate offer can be used as a down payment on one of these vehicles, reducing both the loan payments and the risk of negative equity.
Buy a Certified Pre-Owned (CPO) vehicle: Most new car dealers offer these lightly-used vehicles, which have been thoroughly inspected and come with generous warranties that are backed by the manufacturer. CPO vehicles cost significantly less than new vehicles. Even better, you avoid the first few years of massive new car depreciation.
Refinance your underwater loan: If you need a new car, and your previous loan from another lender is threatening to drown you in negative equity, contact us at Lendbuzz. We will do our best to refinance your old loan and keep you in better financial health, with an APR* and a term that you can live with and afford.
*APR = Annual Percentage Rate.