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Long-Term Car Loans – Why You Should Avoid Financing Over 5 Years

New cars are getting expensive.

From October 2018 to October 2019, new car prices rose by roughly 3%, and as much as 6% in some categories, according to Kelley Blue Book. Meanwhile, inflation rose by only 1.8%.

The average cost was $38,259 for a new light vehicle (car), $51,036 for a full-size pickup, and $63,501 for a full-size SUV (including crossovers). Beyond representing record-highs, these prices are also thousands of dollars more than the median annual income for millennials.

Good thing car buyers now have access to six-, seven-, and eight-year car loans to help them afford these rising prices, right?

Wrong. In fact, by spreading car loans over a longer term and creating the illusion of affordability, lenders may be helping to drive the rise in new car prices.

Here’s what you need to know about the emergence of hyper-long-term auto loans, why you should avoid them, and what to do instead to keep your transportation costs down.

The Rise of Long-Term Car Loans

Not so long ago, a five-year car loan was considered a long-term car loan. It represented the longest loan term offered by many auto lenders.

Today, around 72% of new car loans come with terms longer than five years, according to a 2019 study by Experian. Even the majority (62%) of used car loans are now longer than five years.

The number of extremely long-term car loans — between 85 and 96 months — rose by 38% between 2018 and 2019.

In short, Americans are spending more on cars and simply spreading that cost over a longer debt horizon. This has created record car debt levels in the U.S. From early 2018 to early 2019, American auto debt rose by 6.5% to reach $1.2 trillion in outstanding balances.

The average new car loan surpassed $32,000 for the first time ever in 2019, clocking in at $32,187. That represents a year-over-year jump of $733.

On a monthly basis, the average payment reached $554 — a number that would be higher if balances weren’t spread over so many years.

Kicking the can down the road with longer-term debts comes with its own risks and downsides.

Why You Should Avoid Car Loans Longer Than 5 Years

Consumer debt is awfully tempting. Creditors offer you instant gratification: You get what you want right now, and you don’t have to pay for it until later.

Consumer debt begets more debt, however. The interest keeps coming, even as you keep spending beyond your means.

It’s a vicious cycle, and particularly damaging for vehicle expenses because they make up the second-largest expense for most Americans, according to the Bureau of Labor Statistics.

Before you accept that hyper-long-term car loan, consider the following reasons to keep your auto debt at five years or shorter.

Higher Life-of-Loan Interest

The longer your car loan, the more you pay in interest. There are two reasons for this.

First, lenders nearly always charge higher interest rates for longer loan terms. Lenders price their loans based on risk, and the risk of default is higher over a longer loan term, especially when secured against a rapidly depreciating asset such as a vehicle.

Second, longer loan terms mean more months to spread out interest amortization. Even if we hold interest rates constant, longer loans mean higher life-of-loan interest.

For example, the average car loan in the U.S. currently costs 6.16% in interest, according to Experian. If you finance the purchase of an average new car for $38,259 at 6.16% interest, here’s how the numbers play out at different loan lengths:

  • 3 Years (36 Months): Monthly payment: $1,166.69. Total life-of-loan interest: $3,741.84
  • 4 Years (48 Months): Monthly payment: $901.32. Total life-of-loan interest: $5,004.36
  • 5 Years (60 Months): Monthly payment: $742.50. Total life-of-loan interest: $6,291.00
  • 6 Years (72 Months): Monthly payment: $636.96. Total life-of-loan interest: $7,602.12
  • 7 Years (84 Months): Monthly payment: $561.85. Total life-of-loan interest: $8,936.40
  • 8 Years (96 Months): Monthly payment: $505.76. Total life-of-loan interest: $10,293.96

The difference in total interest paid between a three-year loan and an eight-year loan is nearly triple the cost. And that says nothing of the higher interest rate likely to be charged on an eight-year loan.

Risk of Negative Equity

When you owe more than your car is worth, you’re “upside-down” on your loan. Put another way, you have negative equity.

This is a real risk when you take out a car loan with a term of six, seven, or eight years.

Negative equity means coughing up the difference if you want to sell the vehicle. If after five years you still owe $10,000 on your loan, but your car is only worth $7,500, you may not have $2,500 to make up that difference.

You might need to eat the cost if you need to replace the vehicle. Your needs might change — for example, if you have a child or move to an area where you need four-wheel drive for snowy or muddy roads.

For that matter, if you get into an accident and the insurance company writes off your car as a total loss, they pay the value of the vehicle, not your loan amount, which means you’re on the hook for the difference.

Although there are a few strategies to get out of a car loan when you’re upside-down, you’re better off avoiding that situation in the first place.

Debt Outlasting the Car’s Health & Warranty

Manufacturers know how long the major components in their cars are likely to last, and they structure their warranties accordingly. That’s why they only offer a five-year warranty on many of those components.

After five years, cars typically start needing more significant maintenance and repairs than the occasional oil change and new tires. You start seeing transmission problems, engine problems, and other expensive issues.

With a five-year loan, you cease making monthly payments around the time the risk of major repairs starts rising. It’s a lot easier to manage a $2,500 repair if you’re not also making a $700 monthly car payment, and it’s easier to budget for car repairs properly in your emergency fund.

Overextending Yourself Financially

If you can’t afford a car on a 60-month loan, you probably can’t afford that car. And the farther into your future you tie yourself up with debts, the more you sap your long-term saving and investing potential.

People come up with all sorts of justifications to overspend on a car, like “I need to impress clients,” “I need plenty of cargo space,” or “This SUV is safer for my children (even though it’s statistically not as safe as that less sexy minivan).”

You can contort logic all day long, but ultimately, people get excited about cars and make emotional decisions. Dealers are all too happy to exploit this by offering to lower your monthly payment and let you pay them back a little longer.

Your car is an expense. Buying it makes you poorer, not richer. The less you spend on it, the more you can put toward true investments that generate passive income and make you wealthier.

How to Avoid Overspending With Long-Term Car Loans

You have a range of options to help you avoid long-term debt commitments on a car. What these strategies all have in common is that none of them give you instant gratification.

Dealers want to tempt you to spend as much as possible, offering to let you drive out the door today with your dream car. That’s what’s best for them, but it’s not what’s best for you.

Instead of letting them tempt you to overspend with a long-term loan, try these tactics to lower your monthly payment.

Improve Your Credit Score

With a better credit score, you can qualify for a lower interest rate, which means a lower monthly payment for a shorter-term car loan.

Start working on improving your credit score right now, before you’re ready to buy a car. It takes months, often years, to improve your credit significantly. The sooner you start, the more likely you are to raise your score enough to qualify for a substantially lower interest rate.

Save a Higher Down Payment

A higher down payment helps lower your monthly payment in several ways.

First, and most obviously, it lowers your loan amount. Even with a traditional three-, four-, or five-year auto loan term, you can keep your monthly payment affordable by putting down more cash and borrowing less.

Second, it can reduce your interest rate. The more you put down, the lower the risk for the lender, so the lower they can go with the interest rate. Even with that, however, to see the best possible interest rate, you need to negotiate for it.

Negotiate a Lower Interest Rate

Everything in life is negotiable, and interest rates are no exception. You can negotiate your car loan the same way you can negotiate a home mortgage.

Having strong credit and a higher down payment puts you in a better position to haggle. You can also point to your high income relative to the car loan, the stability of your job, and perhaps even a co-signer if you’re young or have weak credit.

Most importantly, play different lenders off of each other to score the best loan terms. That means comparison shopping.

Comparison Shop Before Visiting the Dealer

Car dealers offer financing for two reasons: they want to close the deal same-day, on the spot, and they often make money on the loans as a middleman.

Instead of playing that game, talk to multiple lenders before you go car shopping. Start with your bank or credit union, since you already have a relationship with them.

But don’t stop there. Collect a range of quotes through online comparison websites like LendingTree to get a complete sense of the options and rates available.

Be especially wary of dealers offering a financing incentive, such as 0% interest for a certain number of years. Even if a high interest rate doesn’t kick in until after a few years, you’d better believe the dealer is making money on the transaction one way or another.

If they’re subsidizing your financing cost, it’s because they overcharged you for the car itself.

Instead, look for rebates and discounts as your dealer incentive of choice. Get cheap financing elsewhere, scout out the best dealer discount in your area, and bring proof of credit to the dealer to help negotiate an even lower price.

Consider Leasing

If you’re the kind of person who absolutely must drive a new car every few years, consider leasing a car instead of buying.

Leasing comes with a few downsides. All of your monthly payments go to the dealer, and none go toward paying off a principal balance. At no point do you have a car you’re not making payments on. And, of course, the dealer makes a profit on you each and every month.

Still, leasing usually makes more financial sense than buying a new car every two years and trading it in.

Buy Used (Or Just Spend Less)

Better yet, lower your monthly payment by spending less on a car. Buy a used car or a less expensive new model.

Although depreciation varies by make and model, new cars often lose 20% or more of their value in the first year of ownership, according to Carfax. That’s a huge drop for a car that’s only one year old.

Used cars do come with slightly higher risk, as you don’t know the car’s maintenance or damage history for sure. (Not all accidents and repairs get reported.)

But you can buy certified used cars or buy additional warranties, and the manufacturer warranty usually transfers along with ownership. If you want to save money and lower your monthly payment without extending your car loan until you’re gray, consider buying a used car rather than a new one.

Buy With Cash

There are good reasons to buy a car with cash. From saving thousands of dollars on interest to eliminating the risk of becoming upside-down to lost rebates and discounts on the car’s price, buying with cash often makes far more sense than financing.

Beyond the usual reasons, though, buying with cash tempers the temptation to overspend on a car. When you have to write a check for the full amount of the car, rather than just sign on the dotted line of a lease or loan, it makes the true cost to your net worth tangible.

You know exactly how much you’re spending — you feel it viscerally — and as a result, you spend less.

Plus, you’re limited to how much cash you actually have available, which also helps force you to spend less.

Don’t Buy a Car at All

For the last four years, my wife and I shared a car. A few months ago, we got rid of it entirely.

Imagine having an extra $9,300 in your pocket every single year, for every car in your driveway. That’s how much the average car costs annually in car payments, maintenance, repairs, gas, insurance, parking, and more, according to AAA.

Getting rid of a car is no small budget tweak. It may involve restructuring your entire life, including a move to a more convenient location. But considering that transportation is the second-largest expense for most Americans, it offers some of the greatest potential for savings.

Alternative forms of transportation include walking, biking, carpooling, public transportation, ride-sharing services such as Uber, and car-sharing services such as Zipcar. You could even split a car with a few friends or neighbors to share the costs.

Do Long Car Loans Ever Make Sense?

In rare cases, car loans with terms of more than five years can make financial sense. But that’s only under specific circumstances, and only for diligent savers and investors.

One such case is if you’re aggressively paying down debts at a far higher interest rate than the car loan in question.

If you have $25,000 in credit card debts costing you 22% in interest, and you can borrow a car loan at 4.5% interest, it makes more sense to pump all of your cash toward paying off your credit card debt, rather than using cash to buy a car outright, put down a large down payment, or make higher monthly payments on a standard-term loan.

The other case is if you’re confident you can earn more by investing the money than you lose in interest. For the average car buyer, however, earning average returns and paying an average interest rate of 6.16%, this strategy offers more risk than reward.

Both of these cases revolve around one central premise: that you’re taking all the money you’re saving each month by lengthening your loan and putting it to work for you rather than spending it. But few people have that level of discipline.

Final Word

When shopping for a new or used car, stick with standard loan terms of three, four, or five years. It saves you money on interest, both by shortening your amortization schedule and by typically offering a lower interest rate.

If you’re already locked into a long-term car loan, aim to pay it off early so you don’t find yourself strapped with negative equity and major car repairs while still shelling out monthly payments. You can follow many of the same principles for paying off a mortgage early to get out from under a high auto loan.

Ultimately, car dealers play to your desire for instant gratification when they offer long-term car loans. Don’t succumb to their psychological tricks, don’t overpay for a car, and don’t strap yourself with lengthy auto debt. It’s not worth it.

G. Brian Davis is a real estate investor, personal finance writer, and travel addict mildly obsessed with FIRE. He spends nine months of the year in Abu Dhabi, and splits the rest of the year between his hometown of Baltimore and traveling the world.