Money Mondays: Why Long Term Car Notes Are A Bad Idea

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Tom: You join us this morning with some news about auto loans.

Mellody: I do have news, Tom, but it is worrying news. A new report out from Experian tells us that the average term of auto loans – both for new and used car sales – are getting stretched to record lengths. On top of that, the average amount financed for new vehicles, and the average monthly payment for new automobiles, have also hit record highs in the first three months of the year. Combined, these mean that consumers could get themselves in trouble with auto loans, Tom, and our listeners need to be careful if they are considering buying a car.

Tom: How long are these new loans lasting, and how much are consumers paying?

Mellody: Do you remember when the average term of a car loan was 48 months? Well, those days seem to be long gone. The Experian report I mentioned found that the average new-car loan has reached a record 67 months! That over five and a half years! Even more unsettling, the fastest growing segment of new car loans is those with terms lasting between 73 and 84 months.

The percentage of loans with these lengths reached a new high of 29.5 percent in the first quarter of 2015, up from 24.9 percent a year earlier. Long-term loans for used-vehicle loans also broke records, with loan terms of 73 to 84 months making up 16 percent of all used car loans in the first quarter 2015, up from 12.94 percent.

And it is not just the length of loan terms that are exploding. What people pay for cars is also breaking records. The average amount financed for a new vehicle is now $28,711, up from $27,612 a year earlier, and the average monthly payment for new vehicles also rose to $485.

Tom: What forces are behind these longer loans?

Mellody: There are a couple of factors that are contributing to these longer loan terms. First of all, car companies and dealers changed their approach to financing emerging from the great recession. People were holding on to their cars, waiting to feel more secure about their finances before buying a new one.

We saw the average age of cars on the road spike to over 10 years. So to incentivize people, companies started pushing people to spend less money per month, but more over the long run. This has been helped by very low interest rates, which means that borrowing money has been cheap. This has pushed higher income individuals to finance for longer terms.

The second major factor is wages. We all know that wages have stagnated for most workers over the past few decades. The problem? Car prices have not. So, in order for people to be able to afford new cars, the length of auto loans has had to get longer. Combine that with the fact that people want to buy new, more expensive cars and have the same old low monthly payment, and you have a recipe for much longer loan terms.

Tom: What does this mean for people who may want to buy a car?

Mellody: In general, people should be very wary of these long-term loans. The biggest risk is that when you finance over a longer period, you are adding more interest to the loan, and more time for the car to depreciate. Vehicles currently lose about 13 percent of their value annually, so if your loan is large and stretched over a long period, it is easy to get to a point where you owe more than the car is worth.

To stay in a positive equity position you need to ensure their principal balance is always in line with the vehicle’s value. Used cars are especially risky. Think about it – say you buy a car that someone traded in after a lease. That means the car is already a few years old, and has lost a significant percentage of its value.

If you take out a 6-year loan on this car, you are still going to be making payments on a 10 year old car – one that is ultimately more likely to need costly repairs – and you are going to have negative equity on it. Then, if you trade it in, you could be in a position where you get into a cycle of adding that previous negative equity to your next auto loan. So there is a lot of risk with longer financing periods, Tom.

Tom: What should we keep in mind if we are buying a car?

Mellody: The biggest thing you need to keep in mind is that you should not buy a car unless you can afford it. And when I say afford it, I mean pay it off in under 5 years. The other thing you need to remember is to avoid getting caught in an underwater equity position. Whether it is long financing, or using a subprime loan, do not get into a situation where the amount you owe is more than the value of your vehicle. If you keep these two things at the front of your mind, you will avoid a lot of trouble.

Tom: Thanks the advice, Mellody! Have a great week.

Mellody: Thanks, Tom!

Mellody is President of Ariel Investments, a Chicago-based money management firm that serves individual investors and retirement plans through its no-load mutual funds and separate accounts. Additionally, she is a regular financial contributor and analyst for CBS news and CBS.com.

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Money Mondays: Why Long Term Car Notes Are A Bad Idea was originally published on blackamericaweb.com