The Trade Off with Long Car Loans
You have just test-driven a brand-new car, and you’re convinced that it is just the car for you. You’re all ready to make it your own. Your credit is pretty good, and your monthly income is steady and seems secure. But then you hear that the monthly payment for a conventional $25,000 four-year loan will be $550 at a 3.5% interest rate. You gulp and tell the salesman your budget can’t quite accommodate a monthly payment that big.
“Don’t worry,” he says. “What can you fit in your budget? How about $380 a month? Is that okay?”
You gulp again, but this time you do some mental figuring and decide yeah, I can pay $380 a month. “It’ll be a stretch,” your inner voice tells you, “but it’ll be worth it.”
So how did the $550 payment drop to $380? It wasn’t magic. The salesperson simply moved you to a 72-month loan instead of a 48-month loan. In other words he added two years of monthly payments to your overall cost. By taking the 72-month loan, you’ll end up paying $2,349 in interest instead of the $1,561 you would’ve paid over the course of the four-year loan. That’s almost $800 more.
Now, you might say getting the new car you otherwise would not have gotten is worth the $800. Maybe it is. That’s a value judgment, and we’re not here to judge you, just to advise you. Because there’s another potential issue here, too.
What are we talking about? We’re talking about being “under water” or “upside down.” The longer the loan the more likely this is to happen as you move toward the middle of the loan period. Being upside-down means you owe more on the car loan than the car is actually worth. In other words, you can’t pay off the car loan from the proceeds of selling or trading in the car.
That’s just a minor footnote not even worth mentioning if you keep the car through the entire length of the loan and pay it off. But if circumstances change and you decide you need a different car, you’ll have to pay the difference to retire your car loan and get a new one. And that difference could be hundreds of dollars. Many people “solve” that problem by adding that “gap” or dollar difference to their next new-car loan, but you can see the implications of that – you’re borrowing more money and paying a larger monthly payment not just based on the new car you are getting but also on the previous car you are trading in. Suffice it to say, Warren Buffett wouldn’t do it that way.
So as to the pluses and minuses of long car loans, the obvious and perhaps only plus is that they can result in lower monthly payments. On the minus side, you will pay longer and you will pay more in interest even if the interest rate for the longer loan is the same as for the shorter one. Additionally, with a longer loan you run more risk of being “under water,” which means it will be expensive to switch from your current vehicle to another one during the course of the loan. Whatever you decide, we suggest you take a few minutes to think about it. Why make a split-second decision that could cost you $1,000?