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Post: Autotrader: Is 72 months too long for a car loan? The problems with long-term loans.

The issue with taking the one-size-fits-all approach to a topic like the right car loan length is that it doesn’t take into account, well, you. In other words, your age, monthly budget, creditworthiness, and so forth is different than your neighbor’s situation. If your credit score is 750, you have a completely different perspective on borrowing money than your neighbor with a 600 credit score.

We aim to provide general advice for the average borrower. But even if you are on the far extremes of the credit-score bell curve (above 800 or below 500), you can still benefit from the advice presented here.

Muddying the water, the current auto market is affected by a worldwide microchip shortage and breakdowns in the supply chain. According to analysts at Cox Automotive (the parent company of Autotrader), by the fall of 2021, the average new car was selling 2% above the manufacturer’s suggested retail price. Prices have climbed higher still. In other words, buyers paid more than the carmakers were asking for the car because demand outstrips supply.

Getting a handle on what borrowing strategy will work best for you in this volatile automotive market is more challenging than it has ever been.

Why buy a car on credit?

Let’s face it, most of us can’t pay cash for a new or even a recent-model used car. According to the credit experts at Experian
less than 16% of new car purchases in the final quarter of 2021 were cash transactions. For the other 84% of us, that means borrowing the money from a lender and paying it back month by month until the loan is paid in full.

Experian reports the average new car loan amount during the fourth quarter of 2021 was $39,721, with an average monthly payment of $644. That loan amount is up 12% from the same period in 2020. The average loan term in the fourth quarter of 2021 was almost 70 months, with an average interest rate of 3.86%.

Financing isn’t as critical to most used-car buyers. Statistics show that nearly 61% of fourth-quarter 2021 used car sales were cash transactions. During that period, the average amount financed on used cars was $27,291 at 8.2% interest. That financing amount is more than a $4,600 year-over-year increase. The average term for used-car loans was 67.4 months at $488 a month.

However, very few of us are average. Once we’ve decided to buy a new car and borrow the money to do so, we need to figure out what length (term) of a loan will best fit our budget.

So if you’re wondering what the typical car loan length is and what terms you should choose, this article should answer most of your questions:

Plus: Used cars cost more than new ones? Here’s what’s going on, and where to find the bargains.

How long can I finance a car?

You may be able to find lenders that will customize car-loan terms, but that’s an exception and not a norm. The most common terms for car loans are 24, 36, 48, 60, 72, and 84 months. A few lenders will even go as high as 96 months. However, again, that’s an exception and not the norm.

What’s the difference between a 24-month loan and an 84-month loan? The simple answer is that the longer the term, the lower the monthly payment. Okay, problem solved, right? What’s to decide? The math seems to say you should go with the longer term and the lower payment. However, there’s actually more to it than that.

What are the disadvantages of long-term loans?

When you take out a car loan of any length, you don’t buy the car; the lender does. In other words, the lender pays the seller for the vehicle. Your monthly payments repay the lender. The car doesn’t belong to you until you pay the lender all the money you borrowed. The lender doesn’t loan you the money out of the goodness of its heart. With your signed promise to pay the lender back, you also agree to pay a fee (the interest rate) for using that money.

When you’re signing the paperwork at the dealer, you’ll face the temptation to accept longer loan terms. There’s a reason for that: Monthly payments become lower when stretching them out over a more extended period. Initially, that might seem like it’s more cash in your pocket, a good thing.

But the longer the loan term, the more you will pay for using the lender’s money. So, although your monthly payments will be lower for a 72-month loan than for a 48-month one, you will wind up paying more for the car. Moreover, many lenders raise the interest rate percentage as the length of the loan increases. You may pay a higher interest rate for a 36-month loan than for a 24-month loan.

For example, using Autotrader’s monthly car payment calculator, financing $20,000 of a car purchase at 4.5% for 36 months will cost $1,418 in interest over the life of the loan. If you finance the same amount at the same interest rate for 72 months, you’ll spend $2,859 in interest over the life of the loan. That’s an extra $1,441 you will pay for that car. And that’s if the interest rate itself doesn’t increase with the longer term.

Read: Used EVs: How to navigate the tight market for pre-owned electric vehicles like the Nissan Leaf and Chevy Volt

There’s more to consider

Let’s say you are willing to bear the additional cost of a 72-month loan to score lower monthly payments. Paying a higher fee for using the money isn’t the only disadvantage a longer-term loan involves. Here are two other issues to consider.

First, when using a long-term loan, you won’t have any equity in the car until very close to the payoff date. That means you will owe more than the car is worth up until the final few payments. It will have no benefit as a trade-in if you want to buy another vehicle. A lender will roll the difference between its value and the amount you owe into your next car loan.

Second, most new-car warranties have expired long before a car is five or six years old. With a longer-term loan, you may well find yourself paying for expensive repairs on a vehicle on which you are still making monthly payments. Neither of these issues makes financial sense for you or your family.

See: It’s a tight market for the first-time car buyer: How to find the best deal, new or used

What are the disadvantages of short-term loans?

So why not go for a short-term loan and take advantage of a lower rate? For most of us, the main problem is the size of the monthly payment for short-term loans. After all, it’s no fun making luxury car-like monthly payments on a nonluxury car, such as a Honda Accord or Toyota Camry, even if you know that it is the more intelligent financial decision.

For another example, return to our monthly car payment calculator. If you finance $20,000 of a car purchase at 4.5% interest for 36 months, the payment is $595. Financing the same amount at the same interest for 60 months works out to a monthly payment of $373.

We all face restrictions with monthly budgets and often have no choice but to spread out the cost of a vehicle. However, avoid loans over 48 months if you can.

How do interest rates impact car loan terms? 

Beyond the length of a loan, your credit history and other factors can affect your actual interest rate. According to Experian, interest rates for new cars in the fourth quarter of 2021 averaged 3.86% and 8.21% for used. Here’s an example of the difference in the monthly payment and the total cost of interest for two different interest rates.

Let’s make another visit to Autotrader’s monthly car payment calculator with our $20,000 amount to finance. Financing that amount for 60 months at 3.86% works out to a monthly payment of $367 with a total interest cost of $2,024. Financing at 5.0% for 60 months comes out to $377 a month with a total interest cost of $2,645.

Getting the best interest rate you deserve can save you money, no matter the loan length.

Is a short-term or long-term loan better?

In the end, our advice is simple: When you’re buying a car and considering a car loan, opt for the shortest term and the best possible interest rate. This option might not be the most appealing idea, considering it will increase your monthly payments. Plus, it may limit the type of car you can afford. But down the road, you’ll thank yourself when you’ve saved thousands in interest and paid off your car years before you thought you would.

This story originally ran on Autotrader.com.

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