If you’re looking to buy a new car, you might be offered a longer and “cheaper” loan. Don’t be suckered in — it’s bad business all the way around. I know it doesn’t sound that serious, but consider this: According to Edmunds.com, 40% of new-car buyers owe more money on their trade-ins than the cars are worth. The average person in this group is “upside down” (see “It’s Good to Know,” below) in the loan for more than $2,200. So almost half the people buying new cars are screwed. They have to dip into their bank accounts to get rid of their old cars.
This problem is largely due to longer loan terms. Three- to four-year car loans used to be the norm. Now, there are six-, seven-, and even eight-year loans. About 84% of loans are for four years or longer. I’ve mentioned many times that buying a new car is always a losing proposition. The car’s value declines about 30% in the first year, and from there it just tanks. And it’s never a good idea to borrow money to buy something that depreciates.
These longer loans make the situation even worse. They make a little sense if you’re going to keep the car for longer than the loan time — but even then, the reasoning is marginal. For openers, the longer the car loan, the more interest you pay. On the typical eight-year, $30,000 loan, the extra interest comes to about $4,000. Maybe that doesn’t sound like much when it’s stretched out over eight years — but it will just add insult to injury, because that’s not the only thing to worry about when considering one of these long-term loans.
Think about this: How happy would you be making the same payment on the same car for eight years? Getting out of the loan early may not be possible. The financial burden could last much longer than eight years. You could get stuck with repair bills AND car payments. Here’s how an eight-year loan would likely unfold: For the first few years, it seems like a decent deal — but then the car begins to wear and newer models arrive.
All of a sudden, your car and your payment schedule aren’t so appealing, and you aren’t even halfway through the loan. At this point, your options are limited. You can live with the car (and the same payments) for up to five more years. In that time, the warranty can expire, in which case, in all probability, you’ll have significant repair bills to deal with. Or, you can get rid of the car. If you do that before the loan is up, chances are the loan will be “upside down.” If that’s the case, you’ll have to swallow the difference.
The same thing happens if the car is lost or stolen. Insurance will pay only what the car is worth — and you’re still responsible for paying off the remainder of the loan, despite the indemnity. (See “Word to the Wise,” below.) There is one more option — but if you take it, you’ll have to wear a dunce cap for a very long time. If you try to trade in a car with an upside-down loan, the car salesman will probably suggest that you simply pay off the old loan by borrowing the additional money through your new car loan.
In some cases, a person can borrow up to 140% of the value of the new car in order to do this. They’ll probably even let you borrow the money for up to eight years. Do this, and the above problems will be multiplied. And remember, even with loans shorter than eight years, you can still run into many of the same problems. Obviously, the best thing to do — if you can afford it — is buy a late-model used car and pay cash for it.
But what if that’s not an option for you? “Think of your money like a mortgage lender does,” financial planner Chris Cooper told CNN/Money. Here are some good guidelines to follow: If you’re going to buy a house, lending institutions don’t like to see more than 36% of your gross monthly income going to debt. Of this, they feel about 28% should go toward housing. That only leaves 8% for other debts — including a car payment.
For example, if you make $60,000 a year, your monthly gross pay is $5,000. Eight percent of that is $400 — the amount that should go toward all your other debts. If you have outstanding credit-card balances, student loans, etc., deduct those payments from the $400. What’s left is what you can afford to spend on a monthly car payment.[Ed. Note. Mark Morgan Ford was the creator of Early To Rise. In 2011, Mark retired from ETR and now writes the Palm Beach Letter. His advice, in our opinion, continues to get better and better with every essay, particularly in the controversial ones we have shared today. We encourage you to read everything you can that has been written by Mark.]