Most people have a rough idea of what monthly payments will fit their budget when it comes to buying a car. That figure is usually what they target when they're making a deal. However, this monthly-payment mentality is making car buyers lose track of the bigger picture: the total cost of the car and the length of time it will take to pay it off.
Edmunds data tells the story: Since 2002, the average car loan term has slowly crept past five years, and is now inching past six-and-a-half years. In 2014, 62 percent of the auto loans were for terms over 60 months. And nearly 20 percent of the loans were for 73- to 84-month terms.
"Consumers are battling two things," says Melinda Zabritski, director of automotive credit at Experian. They are trying to get a good interest rate and a reasonable monthly payment. But sometimes the five-year loan has a monthly payment that is too high for them, and they end up financing for a longer term, even if it costs them more down the line, according to Zabritski.
Is there any benefit to having a six- or seven-year car loan? Aside from having a lower monthly payment, no. In fact, there are many reasons why you shouldn't choose such a long car loan term.
Higher Interest Costs
The longer you finance a car, the more interest you will have to pay on it, both in terms of the rate itself and the finance charges over time. Edmunds recommends a 60-month loan, less if you can manage it. Here's how the numbers look when you compare a 60-month loan to a 72-month loan.
We chose a 2015 Toyota Camry XLE V6 with a few options as our example. Its True Market Value (TMV®) is close to the average price of a new car in 2014. Edmunds data shows that the average down payment for a 55-60-month loan in 2014 was $4,689. We entered those numbers in our loan calculators. After tax, title and the down payment, the total amount to be financed was $29,800.
The average interest rate for a 55-60-month loan in 2014 was 2.41 percent, according to Edmunds data. The buyer would have a monthly payment of $528. The finance charges over the life of the 60-month loan would be $1,861.
Contrast that with a 72-month loan we plugged into our calculator. The interest rate would be higher, according to Edmunds data: It was 5.9 percent for loans of 67-72 months in 2014. It's common for longer loan terms to carry higher interest rates, Zabritski says.
The data also shows that the longer loan a person takes out, the lower the down payment. People taking out loans in the 67-72-month range had a down payment of about $2,440 in 2014.
In this 72-month loan scenario, the monthly payment, $531, wouldn't be much different from the payment under a 60-month loan, and the buyer would have paid less out of pocket. It may seem like the way to go, until you look at the finance charges.
The finance charges for the loan would be $6,182. That's more than three times the interest for a 60-month loan. And not only will it take the person a year longer to pay off the loan, it will also take them longer to build equity in the car. Here's why that's a problem.
Negative Equity
A new car typically depreciates about 22 percent in its first year. At the beginning of a car loan, the buyer is typically "upside down," or "under water," meaning he owes more than the car is worth. The situation is made worse if the buyer hasn't made a large enough down payment.
Based on Edmunds data, most people aren't making a big enough down payment to keep from being upside down longer than necessary.
The time it takes you to get "above water" and build equity in the car will vary, based on the car you bought and how much of a down payment you've made. But one thing doesn't vary: The longer your car loan, the longer it will take you to build equity.
When you have no equity in the car, you can't sell if it you need the money in an emergency: if your other bills get out of hand or you lose your job, for example. It also gives you fewer options if you get tired of the vehicle. A buyer will only pay you what the car is worth, not what you owe on it. You're stuck with the balance of the loan.
Similarly, if you get into an accident and the car is totaled, the insurance company will only pay you what the car is worth at the time of the accident. The remainder of what you owe will have to come out of your pocket.
Car Fatigue
We love our cars when they are brand-new, but when romance fades, we're anxious to trade them in for something else. The average trade-in age for a car in 2014 was six years. It's not what you'd call an enduring relationship.
If you have a 72-month loan and get the itch to buy a new car around the average six-year mark, you wouldn't have enjoyed any time without payments, which diminishes the point of car buying in the first place. At that point, you're better off leasing the car.
If you took out an 84-month loan, you'd have to wait another year to buy. The other alternative would be to roll the balance of the loan into your next car purchase. And that's a bad idea, adding up to an even longer loan commitment and higher monthly payments.
Contrast these situations with buyers who've chosen a five-year loan. At the average trade-in mark of six years, they have already enjoyed almost a year without car payments and have the freedom to sell the car whenever they want.
Low Resale Value
Resale value is another reason to steer clear of extra-long car loans. A 5-year-old car is more desirable and more valuable in the used-car marketplace than one that's 7 years old.
At five years, a car has lost about 53.5 percent of its new-car value in 2014, says Joe Spina, Edmunds director of remarketing. A 6-year-old car has depreciated by about 59.4 percent.
In other words, the Camry in our example will be worth roughly $15,554 after five years. It drops to $13,580 at the six-year mark.
A dealership will likely give you more money for the 5-year-old car. At that age, it's a great candidate for the certified pre-owned process (CPO), which means the dealer will have a more valuable car to sell.
On the other hand, a 6-year-old car is right on the edge of no longer being an acceptable CPO car. Some automakers, like General Motors, won't permit a CPO car to be more than 5 years old. Further, if it has too many miles, it won't qualify for a CPO program. That means you will get far less for the car as a trade-in.
Alternatives to Long Loans
Let's say you want to buy a new car, but the monthly payments that are being quoted for the usual five-year loan are too high for you. That may be a sign that you're shopping outside of your price range. Take a look at the Edmunds "What Can I Afford?" calculator. You start by entering your ideal monthly payment.
After you fill out a few other details, the calculator will recommend a price range and some cars that fall in it. Stick to cars at the lower end of the range and you should be in good shape. Once you have an idea of what you can afford, make sure you get approved for your car loan before heading out to the dealer.
You also could consider buying a used car. Interest rates are a bit higher for used cars, but since the cars cost less, there's less to finance and the payments will be lower. If you're not sure what cars to look at, check Edmunds' Best Used Cars. It will point you in the right direction.
Final Tip
While it is important to know what you can afford in terms of monthly car payments, that shouldn't be your only measurement of a good car loan. Take a look at all the numbers in the sales contract so that you are fully aware of what you are paying for the car.
