By Ronald Montoya
The traditional “4/20/10 Rule” of buying a car stipulates that you must pay a 20% deposit, have a loan not exceeding four years and a total monthly budget for the car not exceeding 10% of your net salary. But the reality is that only 6% of new car buyers actually took that advice in March, according to sales data from Edmunds. The average loan term for a new or used car has steadily increased over the past decade and is now around 70 months.
The longer loan terms not only reflect a trend of people looking for a way to offset paying for more expensive trucks and SUVs, but also inflated prices due to a nationwide vehicle shortage. At today’s car prices, the old rule of thumb is not only ignored, but also unattainable for most Americans.
“Low inventory continues to wreak havoc on new and used vehicle markets,” said Jessica Caldwell, Edmunds’ executive knowledge director. “Buyers who can actually get their hands on a vehicle are committing to average payments and loan terms never seen before.”
In March, 73.4% of loans financed were over 60 months. The most common term was 72 months, followed closely by an 84 month loan. The trend is less good for used car loans. Just over 80% of used car loan terms were longer than 60 months, with 72 months being the most common term.
A longer loan has the carrot on the stick of a more acceptable monthly payment, but it comes with a number of downsides.
HIGHER INTEREST CHARGES
The longer the term, the more interest you will pay on the loan, both in terms of the rate itself and finance charges over time. Let’s take a look at how the numbers change on two loans that are on opposite ends of the financial spectrum.
The average loan amount for a new car in the first quarter of 2022 was $39,340. If we opted for the recommended term of 48 months, it would have an average interest rate of 1.9% in March 2022. Finance charges over the life of the loan would be $1,545, giving you a staggering monthly payment of $852. It’s easy to see why someone would opt for a longer loan.
Compare that with an 84 month car loan. The monthly payment would drop to $563 with an interest rate of 5.4%. Seems like a massive improvement over 48 months – until you see the finance charge: $7,990 over the life of the loan. That’s $6,445 more on the 48-month loan, yet 34% of new car buyers are willing or forced to make that trade-off.
Now suppose you purchased a lightly used car with a loan term of 72 months at an average financed price of $30,830. Your monthly payment would be $559. This seems somewhat reasonable from a monthly payment perspective. However, interest rates are much higher for used cars, and a rate of 9.2% is quite common. You would pay $9,403 in finance charges.
Many car loans start out in a negative equity position, meaning you owe more on the loan than the value of the vehicle due to finance charges and initial depreciation of around 20-25%. The time it takes you to build equity in the car will vary depending on the resale value of the vehicle, the term of the loan and the down payment. With a 48 month loan, you will break even in around 25 months, whereas it would take you 40 months on an 84 month loan.
Having negative equity can limit your options if you’re in dire financial straits or tired of your car before it’s paid for. A buyer will only pay you what the car is worth, not what you still owe, so you will be obligated to pay the loan balance.
TIPS TO AVOID A LONG CAR CREDIT
Buy a less expensive vehicle. It might not be what you want to hear, but if the payouts are making you cringe, chances are you’re buying above your budget. Ask yourself: do you really need a midsize SUV when a compact SUV will handle most tasks with ease?
Consider buying an old used car. Look for something around 6-7 years old. Yes, interest rates are higher for used cars, but since these vehicles cost much less, there is less to finance and the payments will be lower. This approach should help make a shorter-term loan more accessible.
Since 48 month loans aren’t practical for most people, we recommend a 60 month car loan if you can afford it. This is a more realistic sweet spot that combines a lower interest rate with a manageable monthly payment, provided you make a solid down payment.