The “Great Recession”, low wages, and lack of job security have meant that you’ve been putting off replacing your worn out car for several years. Unfortunately, you can only wait so long. Soon, you won’t be able to afford the repair costs of keeping your car on the road. You may not want to replace your car, but you don’t have a choice. You pull together a small down payment and drive out to the car lot. The first thing the salesman asks you is “what kind of monthly payment are you looking for?” It’s that focus on the monthly payment that will get you into trouble and lead you to spend more money on a car than you should.
Right now, approximately 1/3 of new car loans are long-term, lasting 6 years or more. Why are such loans so popular? People are taking longer to pay their cars off so that they can afford the monthly payment on more expensive cars. 6, 7, and even 8 year loans may be popular, but are they really a good idea?
When are long-term car loans a bad idea? For most people, a long-term car loan is a bad idea, especially if you only have a small down payment. Long-term loans spread your payments over a longer period of time in turn, giving you a lower payment. However, the flip side is that you will pay more in interest over the life of the loan.
Long-term loans also mean that your car loan will be underwater (you owe more on the car than it is actually worth) for a much longer time. Most of a car’s depreciation occurs in the first two years. You can expect your car to depreciate as much as 40% in just 24 months. You know that it is unlikely that you will pay 40% off your car loan in that same two years. The difference between how much you owe on your car loan and the value of the car is what determines how upside-down you are on your car. If you try to trade your car in or buy a new car while your current car is underwater, the new car deal will end up costing you a whole lot of money. This is because what you owe on your old car will be rolled into your new car loan, meaning bigger or longer payments. In this case, your new car will be underwater for many years.
When are long-term car loans a good idea? Is it absolutely necessary for you to have that expensive new car or truck? Do you have a down payment of 20% or more? Is the manufacturer offering you a zero percent interest loan? Under circumstances like these, taking on a long-term car loan might make sense for you. Zero percent interest over the life of the loan negates the argument against the added interest you would normally pay. Having a large down payment reduces the amount of time that your car will be underwater.
Still, you will reach the point where you will need to start making repairs on a car for which you are still making payments. Think twice before committing to a car loan that will have you making a car payment for more than 5 years. The next time a car salesperson asks you “what kind of monthly payment are you looking for?” tell them you are more interested in knowing what the car will cost. If you don’t like their answer, walk away.