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Edmunds: Shoppers should think twice about long-term loans

RONALD MONTOYA of Edmunds

Car buyers have collectively blown past the stop sign of the old 48-month “golden rule” for car loans. In fact, 72- and 84-month loans are now more common than ever, propelled by rising vehicle prices and the reemergence of 0% loans. But long-term loans aren’t without pitfalls.

The average car payment for new vehicles hit an all-time high of $584 in April, according to Edmunds sales data. This reflects a trend of shoppers preferring costlier trucks and SUVs, as evidenced by an average amount financed of $37,618. But in an effort to make the monthly payments more palatable, people are taking out longer auto loans, which also hit a record average of about 73 months.

“Car shoppers are showing that they’re comfortable committing to longer loans to get the vehicles that they want right now, especially with the ongoing availability of 0% deals,” said Jessica Caldwell, Edmunds’ executive director of insights.

Long-term auto loans allow people to spend more on a car while keeping the payments low. But many buyers tend to overlook potential issues down the road that can prove costly. Here are a few reasons why a long-term loan can be a problem.

LOW FINANCE RATES WON’T LAST

In May of 2020, about 47% of vehicle loans were financed for under 3%. The low finance rates in recent months are some of the most generous we’ve seen in years. “But these incentives aren’t going to last forever,” says Caldwell. “It’s going to get tougher for car shoppers to find good deals as inventory declines over the new few months.”

Interest rates will go up as the market begins to recover. A few months ago, the interest rate average was closer to 6%. While many shoppers opt to make their monthly payments smaller with a long-term loan, they pay a steeper price in finance charges, especially when rates are higher.

For example, a current 84-month loan on a $37,000 vehicle at 2% would have finance charges of about $1,912. If interest rates go back up to their pre-pandemic levels, that same loan would incur finance charges of $8,404. Plus, not everyone will qualify for the low promotional rates. Those with bad credit will most likely end up with a higher interest rate.

CAR FATIGUE

Americans are not driving their cars “until the wheels fall off.” The data shows they tend to get tired of their cars not long after the loans are paid off, which defeats one of the main advantages of buying over leasing.

The average length of ownership for a new car is about 79 months, according to IHS Markit. Imagine you have an 84-month auto loan, and you get the itch to buy a new car around that common 79-month mark. You’d be stuck with five more months of paying for a car you can’t wait to get rid of.

Contrast this situation with a buyer who chose a five-year loan. At the average ownership mark of 79 months, this buyer has already enjoyed nearly two years without car payments and has the freedom to sell the car whenever the buyer wants.

NEGATIVE EQUITY

A tougher yet more common situation is that you might need to get rid of the vehicle sooner than expected. Perhaps you’ve lost your job and can’t keep up with the payments, or you’re having a baby and your current car is too small. When you try to sell your vehicle, you may owe thousands more on the loan than the car is worth.

As with any long-term loan, you spend the early parts of the loan paying off the interest, which means it will take you longer to build equity. What often ends up happening is that people roll the remaining balance of the loan into their next car purchase. But that creates a longer loan commitment and higher monthly payments for the next car.

DIMINISHED RESALE VALUE

Resale value is another reason to steer clear of extra-long car loans. If you plan on selling your vehicle when it is paid off, a 5-year-old car is more desirable and more valuable in the used car marketplace than one that’s 7 years old. On average, a 5-year-old car will have lost about 48% of its value when new. A 7-year-old car will have depreciated by about 59%. Put another way, the new vehicle in our example will be worth roughly $19,240 after five years. It drops to $15,170 at the seven-year mark.

EDMUNDS SAYS: Low financing rates are a boon to car shoppers. But they can cause people to buy a more expensive vehicle than they need and stretch out the loan term to make the payments manageable. Educate yourself on the other implications of longer loan terms to avoid making the same mistakes.

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This story was provided to The Associated Press by the automotive website Edmunds. Ronald Montoya is a senior consumer advice editor at Edmunds. Twitter: @ronald_montoya8.

Related links:

—Edmunds: 0% loans are a smart way to get out of a bad loan: https://bit.ly/3eRN6iA

—Edmunds: Many car buyers make wrong turn on financing: https://bit.ly/3eOP3vT