When it comes to buying a car, most people have an idea of what monthly payments will fit their budget, and that's what they target when they're making a deal. But this monthly payment mentality is making car buyers lose track of the bigger picture: the total cost of the car and the length of time it will take to pay it off.
Edmunds data tells the story: For the past decade, the average car loan term has slowly crept past five years, and is now close to five-and-a-half years. Thirty-eight percent of the auto loans in 2012 had terms of five-and-a-half years to six years. And 12 percent of the loans were for terms of six to seven years.
"Consumers are battling two things," says Melinda Zabritski, director of automotive credit at Experian. They are trying to get a good interest rate and a reasonable monthly payment. But sometimes the five-year loan has a monthly payment that is too high for them, and they end up financing for a longer term, even if it costs them more down the line, according to Zabritski.
Is there any benefit to having a seven-year car loan? Aside from having a lower monthly payment, no. In fact, there are many reasons why you shouldn't choose such a long car loan term.
Higher Interest Costs
The longer you finance a car, the more interest you will have to pay on it. Edmunds recommends a five-year loan, less if you can manage it. Here's how the numbers look when you compare a five-year loan to a seven-year loan.
We chose a 2013 Honda Accord Sedan EX-L V6 with navigation for our example. Its True Market Value (TMV®) is roughly the same as the average price of a new car in 2012. Edmunds data shows that the average down payment in 2012 was $3,435. We entered those numbers in our loan calculators. After tax, title and the down payment, the total amount to be financed is $30,266.
The average interest rate for a four-and-a-half to five-year loan in 2012 was 2.69 percent, according to Edmunds data. That person would have a monthly payment of $540. The finance charges over the life of the loan would be $2,115.
Contrast that with a seven-year loan. The interest rate would be higher, according to Edmunds data: 4.9 percent for loans of six to seven years in 2012. It's common for longer loan terms to carry slightly higher interest rates, Zabritski says. The monthly payment for a seven-year loan, $426, would be lower than for the five-year loan. But the finance charges for the loan would be $5,548. That's more than twice that of a five-year loan.
It is easy to see how someone could be lured by the appeal of the lower monthly payment afforded by the longer loan. A buyer would "save" $114 per month in car payments, but in the long run he would pay $3,433 more in interest than if he'd chosen the five-year loan. Plus, he'll have two more years of car payments.
A new car typically depreciates about 22 percent in its first year. At the beginning of a car loan, the buyer is typically "upside down," or "under water," meaning he owes more than the car is worth. The situation is made worse if the buyer hasn't made a large enough down payment. Based on Edmunds data, most people aren't making a big enough down payment to keep from being upside down longer than necessary.
The time it takes you to get "above water" and build equity in the car will vary, based on the car you bought and how much of a down payment you've made. But one thing doesn't vary: the longer your car loan, the longer it will take you to build equity.
When you have no equity in the car, you can't sell if it you need the money in an emergency: if your other bills get out of hand or you lose your job, for example. It also gives you fewer options if you get tired of the vehicle. A buyer will only pay you what the car is worth, not what you owe on it. You're stuck with the balance of the loan.
Similarly, if you get into an accident and the car is totaled, the insurance company will only pay you what the car is worth at the time of the accident. The remainder of what you owe will have to come out of your pocket.
We love our cars when they are brand-new, but when romance fades, we're anxious to trade them in for something else. The average trade-in age for a car in 2012 was 5.9 years: It's not what you'd call an enduring relationship.
If you have a seven-year loan and get the itch to buy a new car around the average six-year mark, you'll have to wait another year to buy. The other alternative is to roll the balance of the loan into your next car purchase. And that's a bad idea, adding up to an even longer loan commitment and higher monthly payments.
Contrast this situation with buyers who've chosen a five-year loan. At the average trade-in mark of 5.9 years, they have already enjoyed almost a year without car payments and have the freedom to sell the car whenever they want.
Low Resale Value
Resale value is another reason to steer clear of extra-long car loans. A five-year-old car is more desirable and more valuable in the used-car marketplace than a seven-year-old vehicle.
At five years, a car has lost about 55 percent of its new-car value, says Joe Spina, Edmunds director of remarketing. A seven-year-old car has depreciated by about 68 percent.
In other words, the Accord in our example will be worth roughly $14,787 after five years. It drops to $10,515 at the seven-year mark.
A dealership will likely give you more money for the five-year-old car. At that age, it's a great candidate for the certified-pre-owned process, which means the dealer will have a more valuable car to sell.
On the other hand, a seven-year-old car is right on the edge of no longer being an acceptable CPO car. Further, if it has too many miles, it won't qualify. That means you will get far less for the car as a trade-in.
Let's say you want to buy a new car, but the monthly payments that are being quoted for the usual five-year loan are too high for you. That may be a sign that you're shopping outside of your price range. Take a look at the Edmunds "What Can I Afford?" calculator. You start by entering your ideal monthly payment.
After you fill out a few other details, the calculator will recommend a price range and some cars that fall in it. Stick to cars at the lower end of the range and you should be in good shape. Once you have an idea of what you can afford, make sure you get pre-approved for your car loan before heading out to the dealer.
You also could consider buying a used car. Interest rates are a bit higher for used cars, but since the cars cost less, there's less to finance and the payments will be lower. If you're not sure what cars to look at, use Edmunds' Used Car Best Bets. It will point you in the right direction.
While it is important to know what you can afford in terms of monthly car payments, that shouldn't be your only measurement of a good car loan. Take a look at all the numbers in the sales contract so that you are fully aware of what you are paying for the car.