After Covid, prices for both new and used cars skyrocketed. This was due to a shortage of auto parts that resulted in lower supply combined with pent-up demand as Americans received cash from Covid payouts. More recently, interest rates have climbed, with average rates for new auto loans exceeding 6% for new cars and often around 10% for used. Many consumers have responded by extending the normal four- or five-year loan term to six or even seven years. But is that a good idea?
Lower monthly payments
In most situations, there’s really only one benefit of extending a car loan – lower monthly payments. If you purchased a car for $45,000 (assuming no taxes, fees, down payment, etc.) and your interest rate was 6% for 60 months, you would pay $870 per month. That’s a lot of money. However, if you extended the loan to 84 months with the same assumptions as above, you would pay $657. Normally as you extend the term of a loan the interest rate goes up, so you might end up paying 7% or more for a longer loan.
But so many reasons to say no
In addition to potentially paying a higher interest rate with a longer term loan, there are other problems to be aware of:
Pay more in interest. One of the key drawbacks of an 84-month auto loan is the amount of interest paid over the course of the loan. Interest charges significantly add up due to the extended duration, leading to borrowers paying far more for their vehicles than they are actually worth. This can result in overpaying for a depreciating asset, further exacerbating the financial implications of the loan.
Negative equity. Given that vehicles tend to depreciate rapidly, it is common for borrowers to owe more on their cars than they are worth at any given time. 84-month loans only serve to extend this period of negative equity, as the value of the vehicle will likely decline significantly over the lengthy repayment period. Consequently, selling the vehicle or attempting to trade it in for a new one becomes both challenging and financially inconvenient. And if it’s totaled in an accident, you might not receive enough from your insurance company to cover the outstanding loan balance.
Prolonged financial commitment. 84-month auto loans trap borrowers for an extended period. During this time, life circumstances may change, leaving the borrower regretting the decision and potentially seeking additional financing options or loan restructuring. Additionally, long-term auto loans often morph into subsequent long-term loans. You might total your car early in the payback, meaning you have to purchase a new car while your totaled car isn’t paid off. Or you could grow bored with your current ride and roll the old loan into payments on a new one. You could end up with a car loan that’s 1.5 times the value of the new car.
Car payments plus maintenance. While there are some manufacturers that provide a long factory warranty, many only offer three or five years of coverage. If you have an 84-month loan on a car with a three-year warranty, you will be on the hook for repair costs for four years while still making payments.
One way a longer term might make sense
Manufacturers often offer incentives to move slow-selling vehicles or those that will be replaced by an updated model. While most of these are limited to 60 months, you may be able to find a longer-term offer that financially makes sense. When you have decided on the car you want, research incentives and financing deals. You may even be able to reduce your loan to 60 months. I saw several 0% or 0.99% loans for 60 months. Using the example above, the $45,000 car with a 0.99% loan would cost $769 for 60 months. That’s only about $100 more per month than the 84-month loan, and you’re paying it off two years earlier.
Longer-term auto loans provide lower payments and offer you a chance to buy that shiny new car today instead of waiting. Before you sign the paperwork, consider options like a lower-priced new car or even purchasing something used. If your car is still reliable, perhaps saving a larger down payment might lower the price of the new car enough to reduce the loan term. Plus, recent good news about inflation noted that car prices may have peaked. Maybe just waiting six months to a year for more inventory could help you afford your dream car.
Photo by Yuliia Livshun