How Risky Are Long-Term Car Loans?
Main Street and Wall Street are two different worlds and the disparity between the two is greater than ever. Since the Great Recession, Wall Street has been reaching record highs, which has primarily been driven by prolonged record-low interest rates. Main Street, on the other hand, hasn’t been performing so well. If you went around asking non-investors how they felt about the economy, the vast majority of them would complain. While stocks have recovered from the Great Recession, the rest of the economy has not. Even if you look at many public companies, you will find a lack of top-line growth and a lot of share buybacks to help drive stock prices higher. How does this tie into long-term auto loans?
During the Great Recession, demand for new cars was low. In order to drive new car sales, lenders began to push long-term car loans. By doing so, consumers who would have previously taken out a loan on a used car began taking out loans on shinier new cars. It’s just too tempting for many consumers and car salesmen want to push more expensive cars because they make higher commissions. The problem is that long-term car loans lead to consumers living beyond their means. (For more, see: Bad Auto Loans - The Other Subprime Disaster.)
Living Beyond Your Means?
When a consumer takes out a long-term car loan, they’re intrigued by the lower monthly payments, but they’re really paying much more over the length of the loan because of higher interest rates. And the problems don’t stop there. Most car manufacturers offer a factory warranty of five years. If a consumer takes out a long-term loan that’s longer than the standard 60 months, then that consumer is on the hook for any transmission or engine repairs, which can be financially devastating. Another negative is that technology and safety features will improve over the course of a long-term car loan, but the consumer will be stuck with the old technology. (For more, see: New Wheels: Lease or Buy?)
Long-term car loans have higher default rates than traditional car loans. With a long-term car loan, debt is increased and some consumers end up underwater – paying more than the car’s value. A car is a depreciating asset. Therefore, you want to pay off the debt as fast as possible. The only exception is if a consumer can find a long-term car loan at a very low interest rate. This is rare. (For more, see: Buying a Car: The Worst Investment?)
Long-term car loans - those longer than 60 months - used to be rare. Now they are common. The average car loan is now 67 months, and approximately 30% of all car loans are 72 months or longer. U.S. auto sales have been flying high because of these trends.
Easy lending practices almost always lead to problems. In this case, many consumers are taking on more debt than they can handle. That capital could have been put toward a home (an appreciating asset), retirement or an emergency fund. (For more, see: The True Cost of Owning a Car.)
The Bottom Line
Long-term car loans might offer lower monthly payments, but consumers pay higher interest rates, which leads to a higher overall cost. Any repairs needed past warranty will be the responsibility of the borrower and the trade-in value of the car will be much less when the loan is complete. All consumers should stick to a maximum car loan of 36 months, even if that means buying a less impressive or used car. This is the financially responsible approach, and any saved capital could be put toward a home purchase, retirement or an emergency fund. (For more, see: Why You Absolutely Need an Emergency Fund.)