Pitfalls of longer-term car loans

Parker Trasborg, CFP® November 24, 2017

Eyeing a fully loaded Tesla Model 3 for $60,000 but going with a 72 or 84-month car loan to keep the monthly payment down?  Think again – car loans over 60 months may reduce your monthly payment, but over the long run you will be paying more.  As the cost of new cars has crept up and interest rates have remained low, loans on vehicles with longer terms have begun to become more common.  According to Edmunds.com, the average car loan is now 69.1 months.  There are several reasons to avoid loan terms longer than 60 months:

  • You’ll pay more in interest over the life of the loan. While your monthly payments will be less than a standard 60 month or shorter loan, you will ultimately be paying more for the car over the long-term.  Assuming an excellent credit score, if you take a 5-year new car loan for $30,000 from USAA at 2.99%, you will pay $2,336 in interest over the life of the loan.  If you assume the same terms except stretch the loan to 7 years, you will pay $3,286 in interest instead.  These calculations don’t even take into account that the longer-term loans of 72 and 84 months often carry an interest rate higher than the standard 60 month or shorter loans.  For instance, the current interest rate on an 84-month loan through USAA is 3.99%.  This increases the total interest paid over the life of the loan to $4,434, a whopping 89% more than the 60-month loan.  (rates as of 11/8/17 on USAA.com)
  • You’ll be under-water on the car for most of the loan. Depending on the amount of your down payment, you may end up owing more than the car is worth for several years.  The value of the car for the first few years will depreciate quicker than the principal being paid back on the car loan.  As with a mortgage, a large portion of your monthly loan payments in the first years of the loan goes towards interest.
  • A longer-term loan increases the odds that you’ll trade in your car before the loan term ends. Since longer-term loans may leave you under-water in your car longer, you may end up rolling the negative equity in your current car into the new car loan.  A report from Edmunds.com states that 25 percent of the used car sales in Q3 2016 that included a trade-in included a car traded in with negative equity averaging $3,635.  While gap insurance will cover the difference between the value of your car and what you owe on the auto-loan if your vehicle is totaled, it will not cover the negative equity that rolled from your previous car loan to the new car loan.  If you total your car, you will end up having to continue making the loan payments on the negative equity that rolled from a car that you may have traded-in years ago.

 

According to the Federal Reserve, outstanding auto loans in the most recent quarter (Q3 2017) now total over $1.1 trillion dollars and is the third largest consumer debt behind mortgage debt and student loans.  With interest rates remaining low for so long, longer-term car loans have enabled people to be able to reach and purchase a car that they maybe aren’t able to actually afford.  While this has been a boon for the auto industry, we need to be wary of the long-term effects that such borrowing may have on the overall economy.



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