More on Car Risky Loans
Robert Menard
Certified Purchasing Professional,
Certified Professional Purchasing Consultant, Certified Green Purchasing Professional, Certified Professional Purchasing Manager
The subject of subprime loans for automobile purchases continues to be troublesome. A recent press account sounds the alarm. Susan Tompor of the Detroit Free Press authored “Miles to go on car loans” warned against expensive six to seven year car loans The Tompor story cites a 28 year old auto worker trying to buy a $33,000 Dodge Charger using $10,000 down and no more than a 5 year loan. She writes that Experian the credit bureau, that 40.3% of new car loans ranged from 61 to 72 months and that another 25.7% range between 73 and 84 months. The average term for all new car loans was 66 months or 5.5 years.
According to the story, a three year car loan for $28,000 at 4.5% accrues about $2,000 in interest but the same loan at six years rings in at about $4,000. Car loans are available around 3%, lower for high credit scores, on short term loans of three years. Since the risk of default is inherently higher on loans of five years or more, the interest rate is likely to be higher.
That same $28,000 loan at three years carries a $832.91 monthly payment but the six year loan falls by almost half to $444.47. So you pay half the monthly rate but rack up twice the total interest. That would not seem to be much of a bargain and probably would not be done if more car buyers recognized the financial impact of poor decisions.
What is the allure of the long term loan?
The long term loan depresses the monthly payment so an unwitting buyer can be persuaded that the lower payment “buys more car.” This is utter hogwash but many buyers proudly proclaim this mantra as justification for their ill-advised purchase.
What is worse, no matter if the interest is simple, compound, pre-computed, or almost any other form, the interest curve is steeper in the early years when most of the monthly payment applies to interest. It is generally about half way through the term of the loan when most of the payment applies to principal.
In the online course, How to Buy a New or Used Car,we speak of “being upside down” on a car loan. This happens when a borrower owes more on the loan than the car is worth. We also cite the average statistic that a new car loses half of its value to depreciation in the first three years. This means that if you finance a purchase for six years, not only will you be upside down, but you will be much worse off because the steep interest curve in the early years keeps the loan value much higher than would the three year loan.
Is the rising price tag on vehicles forcing buyers to seek longer term loans?
Of course not. No one is forcing anyone to buy a car they cannot afford. If you cannot pay off a car loan in three years, do not buy the car because you cannot afford it and you are putting yourself at financial risk. Buy a different vehicle, including a used car, which is more in line with your budget, cash flow, and ability to service the debt.