An increasing number of families are buying cars using a loan that has a repayment term of 7 years or even longer, but they do come with risk. In fact, according to Edmunds, it is now estimated that about 20% of purchases now involve this form of financing. It is putting the household as well as parts of the banking system at an increasing level of risk.
There are many reasons for people using these longer term loans. Some of it is for selfish reasons, in that stretching out the payment terms in effect lowers the monthly payments on a car loan. There are other people that are taking out 6-7 year loans as there is no other way they can afford a new car, and with the median age of automobile on the road being about 11 years families sometimes just need to buy a new car.
While have a lower monthly auto loan payment does sound nice, it is also very risky. There are several reasons for this. One of the biggest is the fact that the car will be “upside down” for as long as 5 years. This means that if the family makes their standard monthly payment on the financing, the car will be worth less than the balance of the loan for as long as 4-5.5 years or so. It will in effect take the borrower much more time to pay off the loan and “own” the car.
This means that if they try to sell the car, or if there is an accident that requires a significant amount of repairs, that the borrower will not have any equity left in their automobile. If the car needs work (say new tires or engine repairs) when it is 5-6 years old, in the past a family may decide to either sell it or trade it in, as they may still have some equity in the car. With a seven year loan, this is no longer an option as they will owe more to the bank than the auto is worth.
This lack of equity in any product (whether a home or automobile) was one of the many causes of the housing crisis and the “Great recession” in the late 2000s. Anytime someone owes more money to their bank or lender than the value of the item they bought, this puts the borrower in a very precarious situation. It is also risky for the lender, as an increasing number of defaults can hurt the banking system and economy. This is exactly what happened during the great recession.
Six to seven year long loans also come with a higher interest rate. Borrowing money for these types of purchases may cost the consumer anywhere from .25% to .75% more per year, depending on their credit scores and the lender. This is according to Bankrate. While it may not sound like much, this will cause the family to pay more money in interest each year than principal on the car loan.
Before you buy a new car (or even a used one), be sure to understand all of the financing options. Experts, such as Suzie Orman or even credit counseling agencies, will strongly recommend that a loan of no more than 5 years is used. This will help ensure that the family lives within their means and only buys a car or truck that they can afford. Or if a family already has a high priced loan, they can refinance the note on their auto.
After all, and the end of the day, it is not an auto that is intended to get from point A to point B. Stretching a budget to buy a nicer car just ads more worry and stress. Then you will just worry about any nicks or scrapes on it, not to mention it is just not the risk to overextend a household budget for buying a new car.