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An increasing number of new car buyers are stretching their car loans out further and further. Just five years ago the average loan term for new car purchases was around 60 months, but recently the New York Fed reported that the average loan term is 68.8 months. That’s already two weeks longer than last year. Long story short, auto loans are being taken out with longer repayment terms.
New-car loans of 61 to 72 months, referred to as extended term loans, now make up more than 40 percent of outstanding loans, and 33 percent of longer-term loans are in the 73 to 84-month range according to LendEDU. That’s nearly three quarters of new loan originations that stretch beyond the more conventional 60-month term. What’s behind this trend, and what does it mean for new car buyers and the auto industry?
Buying More Car Than You Can Afford
The primary reason car buyers take out extended term loans is to make their payments more affordable. As car prices have continued to increase, wages in the U.S. have remained flat. Extended term loans can make new cars more affordable based on consumers’ monthly budget.
According to Experian, the average amount financed for new cars has reached a record of nearly $31,000. For consumers to continue to buy new cars without blowing out their monthly budget the options is to extend the loan terms. Car dealers, which are having a more difficult time moving new cars off their lots, are only too happy to oblige. They know that many car buyers are shopping monthly payments versus shopping car prices.
Extended term loans allow car buyers to enjoy that new car smell, even though it can cost them hundreds or thousands in interest over the term of the loan. If you finance $25,000 for a new car at 4 percent over a more conventional 48-month term, your monthly payments would be $564, and your total costs would be $27,100.
However, if you finance the same amount at the same interest rate over 84 months, your payment would only be $342, but your total costs would be $28,700. That may not seem like much of a cost to incur in order to drive off with the latest model, but it doesn’t account for the hidden risks of extended term financing.
You Pay More for the Car With an Extended Term Loan
Simply because of the fact you are paying over a longer period of time, you will pay more in interest costs. But that is only part of the problem. Because extended term loans are a higher risk for lenders, they charge a higher interest rate for the loans. While you can find some low interest deals on extended term loans, your credit has to be flawless in order to qualify for them.
You’ll Be Upside-Down on the Car Loan
Everyone knows what happens to the value of a new car once it’s driven off the lot. New cars depreciate by as much as 20 percent in their first year, and by as much as 60 percent over five years. If you put down a minimal down payment you could be upside-down on your car loan for most of the term. This creates several big risks for car owners. If you total your car when you are upside-down, you will end up still having to pay off the loan. You could buy gap insurance at the time of your purchase to prevent that from happening, but that will increase your total purchase costs.
You could also end up having to pay a dealer out-of-pocket if you want to trade your car in after a few years. The average break-even point on a new car financed with a 60-month loan is 42 months. When you extend the loan to 72 or 84 months, you also extend your break-even period. So if after four years your car is worth $16,000, but you still owe $18,000 on it, you would have to come up with another $2,000 to trade in your car. Most car dealers will find a way to roll that $2,000 into a new loan, but then you enter a vicious negative equity cycle which is difficult to recover from.
How to Move Forward
After understanding the risks of a 72 month auto loan and a 84 month auto loan term, you should proceed with caution. It’s best to avoid extending your loan term unless you can put down a sizable down payment. That would help you address the negative equity issue. Ideally, you have a plan to start accelerating your payments to help pay off the loan early, which can save you thousands in interest costs and out-of-pocket money should you want or need to trade in your car early.
Author: Jeff Gitlen, CEPF®