Why a longer loan period for your new vehicle is a bad idea
The conventional wisdom of car buying once stated that your loan should not exceed 48 months. But the latest data from Edmunds shows that the average loan term for a new car has steadily increased over the last decade and is now about 70 months. These longer loan terms reflect not only a trend of people preferring costlier 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 being ignored but is also unattainable for most Americans.
The traditional “20/4/10 rule” of car buying states that you should make a 20% down payment, have a loan no longer than four years, and a total monthly car budget that does not exceed 10% of your takehome pay. But the reality is only 6% of new car shoppers actually followed that advice in March, according to Edmunds sales data.
A longer loan has the carrot on the stick of a more palatable monthly payment, but it comes with a number of drawbacks.
Higher interest charges: The average loan amount for a new car in the first quarter of 2022 was $39,340. If we went with the recommended 48-month term, it would have an average interest rate of 1.9% in March 2022. The finance charges over the life of the loan would be $1,545, giving you a staggering monthly payment of $852.
Contrast that with an 84-month auto loan. The monthly payment would drop to $563 with a 5.4% interest rate. It seems like a massive improvement — until you see the finance charges: $7,990 over the life of the loan. That’s $6,445 more over the 48-month loan and yet 34% of new-car buyers are willing, or forced, to make that compromise.
Negative equity: Many auto loans start in a position of negative equity, meaning you owe more on the loan than the vehicle is worth due to finance charges and the initial depreciation hit of about 20%-25%. The time it takes you to build equity in the car will vary based on the vehicle’s resale value, the loan term and down payment. With a 48-month loan, you’ll break even at about 25 months, while that would take you 40 months on an 84-month loan.