The Pros and Cons of Long-Term Auto Loans
Long-term auto loans seem tempting. They may make what you want affordable on a monthly basis. And you only live once, right? Yet paying on that dream vehicle for upward of seven years means you’re paying much more overall than you would for a shorter loan (or another car). It might even prevent you from buying other things that are important to you or might be in several years.
The average auto loan is around 69 months, but that has been creeping upward for years. Nearly a quarter of borrowers opt for a 72-month loan today, compared with 10% a decade ago, according to credit bureau Experian, while more new loans are falling into 85- to 96-month terms.
Long or short, your loan term is a personal choice, one made between you and your lender. There are many factors you could consider. But weigh the pros and cons of long-term auto loans before you sign.
A long-term auto loan could help you get into a nicer car than you could afford to buy with a short-term loan or loosen up your monthly budget for other things. A key word is “monthly,” because you will pay more in interest over time.
Lower payment. If you had to pay $100 upfront or $10 each month for a year, most people would prefer to pay $10 monthly, even though it means they’d pay 20% more. This is often how a lower payment works. It makes a large purchase more affordable monthly but more expensive overall.
Many people consider the lower payment worth it as it means they can afford what they want when they want it. Between bills, kids and saving for retirement, it can be difficult to pay a large down payment or take on high car payments or a shorter term.
You should shop around for an auto loan to compare the types of payments you could get for each. It does not hurt your credit score to apply to multiple lenders any more than it does for one lender if you complete the applications in a 14-day window. Possible lenders could include your bank, credit union or online lender. You could also fill out one online form at LendingTree and get up to five potential auto loan offers from lenders.
Nicer car. If you could afford a Honda by taking out a three-year loan, maybe you could afford a Maserati by taking out a seven-year loan. A longer loan could help you to get into a nicer car than you could afford to buy in a short-term loan.
Looser budget. In the same example, if your monthly budget could handle a three-year loan on a Honda, it could afford a seven-year loan on a Honda. This would probably leave you a few hundred bucks a month to save or spend on other things. But it doesn’t make financial sense to take a long-term auto loan if you only plan to blow the extra money.
It does make sense in two cases:
- If you can invest the extra at a higher return than the interest rate you’re paying on the long-term auto loan. The difference between the return rate and the auto loan APR would be money in your pocket.
- If your income varies month to month. If your income is seasonal, commission-based or spotty, a long-term auto loan with lower payments would not put as much stress on you. The idea is that you could meet the lower payments even when your income is low one month, and when you earn more in another month, you could pay more to pay off the loan sooner and pay less interest overall.
Of course, the long-term auto loan is almost always more expensive than a short-term auto loan, either because of higher interest rates or because the loan is for a longer period, building up interest.
Higher APR. Long-term auto loans usually have higher APRs than short-term auto loans. This is for two reasons:
- The first is that people are willing to pay more. Most people are willing to pay the $10 a month for a year instead of the $100 upfront. (If you are the lender, of course you want more money overall.)
- Time value. The second is a concept called the time value of money. Because you are paying back the money slowly, you’re using money for a longer period at a higher cost. And here’s why: If you are borrowing the money for seven years instead of three years, that means someone else can’t use that money for their own loan. In seven years, two other people could have used that same money for a three-year loan.
Higher total interest. Even if the APR doesn’t change, you’ll pay more interest over time. An important part of APR is the “A,” which stands for annual, or yearly. The more years you have the loan, the more you pay.
Higher negative equity. Cars, especially new cars, tend to depreciate faster than you pay on the loan, meaning you owe more money on the auto loan than what the car is worth. When this happens, it’s called negative equity. So if you sell or trade in the car before you’re done paying the loan, you’ll still owe money on the car that you’ll either have to pay off or roll into your new car loan. Rolling negative equity into a new car loan can start a vicious cycle because it creates more negative equity.
If you need low payments, here are some other ways besides getting a long-term auto loan. Consider pairing these suggestions with a short-term auto loan.
Get a cheaper car. New cars depreciate the most in the first year. That’s money out the window. Even a slightly used car can be drastically less expensive and still come with a warranty. If you’re wary of buying used, check out how to avoid buying a lemon car and how to negotiate a car’s price for more information.
Drop the add-ons. One thing that can increase your loan payment is add-ons. Dealerships love to convince you that you need extra warranties and insurance and products ranging from window tint to tire locks. None of those are necessary for the car to run. Drop them and you’ll drop your payment.
Give a higher down payment. This may not be possible if you need a vehicle by tomorrow, but if you’ve got some time, start saving for the car by putting aside the money you would expect to make as a car payment every month and use that money as a down payment. The more you give as a down payment, the less in interest you may pay.
The bottom line
Determine need versus want. Do you need that sports car, or would a Toyota sedan work just as well to get you to work? Choices made based on ego rarely serve the wallet well. Do you need an auto loan for seven years or could you handle the payments on a four-year auto loan without a problem? Don’t sign up for a high-APR, long-term auto loan when you wouldn’t have much of a problem paying on a short-term auto loan.
Look at the overall costs. Don’t just look at monthly payments. The total cost of a long-term auto loan might outweigh the pros.