Edmunds: Longer car loans are a bad idea – Jamestown Post Journal | Car Plazas
By Ronald Montoya
The traditional “20/4/10 Rule” of buying a car states that you should put down a 20% down payment, have no more than four years of credit, and have a total monthly car budget of no more than 10% of your net pay. But the reality is that only 6% of new-car buyers actually heeded this advice in March, according to Edmunds sales data. The average loan term for a new or used car has risen steadily over the past decade and is now around 70 months.
The longer loan terms not only reflect the trend of people looking for a way to offset paying for more expensive trucks and SUVs, but also inflated prices due to a nationwide vehicle shortage. With today’s car prices, the old rule of thumb is not only ignored, but also out of reach for most Americans.
“Shrunken inventory levels continue to wreak havoc on both the new and used car markets,” said Jessica Caldwell, Edmunds Executive Director of Insights. “Buyers who can actually get their hands on a vehicle are committing to unprecedented average payment and credit terms.”
In March, 73.4% of the financed loans had a term of more than 60 months. The most common term was 72 months, closely followed by an 84-month loan. The development of used car loans is worse. Just over 80% of used car loan terms were longer than 60 months, with 72 months being the most common term.
A longer loan has the carrot on the stick of a tastier monthly payment, but it comes with a number of downsides.
HIGHER INTEREST CHARGES
The longer the term, the more interest you pay on the loan, both in terms of the interest rate itself and the cost of financing over time. Let’s take a look at how the numbers are changing for two loans that are on opposite ends of the financial spectrum.
The average loan amount for a new car in the first quarter of 2022 was $39,340. If we were to go with the recommended 48-month term, it would have an average interest rate of 1.9% in March 2022. The financing cost over the life of the loan would be $1,545, giving you an amazing monthly payment of $852. It’s easy to see why someone would choose a longer loan.
Compare that to an 84-month car loan. The monthly payment would drop to $563 at a 5.4% interest rate. It seems like a massive improvement over 48 months – until you see the cost of financing: $7,990 over the life of the loan. That’s $6,445 more than the 48-month loan, and yet 34% of new car buyers are willing or forced to make that compromise.
Now let’s say you bought a lightly used car with a 72-month repayment term at an average financing price of $30,830. Your monthly payment would be $559. It seems reasonably reasonable from a monthly payment perspective. However, used car interest rates are much higher and a rate of 9.2% is fairly common. You would pay $9,403 in financing costs.
Many auto loans start out in a negative equity position, which means you owe more on the loan than the vehicle is worth because of financing costs and the initial write-off of about 20% to 25%. The time it takes you to build up equity for the car depends on the vehicle’s resale value, the loan term, and the down payment. With a 48-month loan, you’ll break even in about 25 months, while with an 84-month loan, it would take you 40 months.
Negative equity can limit your options if you’re short on cash or if you’re fed up with your car before it’s paid off. A buyer only pays you what the car is worth, not what you owe, so you have to pay the balance of the loan.
TIPS FOR AVOIDING A LONG CAR LOAN
Buy a cheaper vehicle. It might not be what you want to hear, but if the payments make you wince, there’s a good chance you’re shopping over your budget. Ask yourself: do you really need a mid-size SUV when a compact can easily handle most tasks?
Consider buying an older used vehicle. Look for something that is around 6 to 7 years old. Yes, interest rates on used cars are higher, but since these vehicles cost significantly less, there is less to finance and payments will be lower. This approach should help make a lower term loan more achievable.
Since 48-month loans are impractical for most people, we recommend a 60-month car loan if you can handle it. It’s a more realistic sweet spot that combines a lower interest rate with a manageable monthly payment, assuming you put down a solid down payment.