How Long Should a Car Loan Be?

Introduction

According to Edmunds sales data, the typical monthly payment for a new automobile reached an all-time high of $648 in the first quarter of 2022. It reflects both higher pricing brought on by a statewide vehicle shortage as well as a tendency of people to favor more expensive trucks and SUVs.

The new and used vehicle markets are still suffering from shrinking inventories, according to Jessica Caldwell, executive director of insights at Edmunds. Customers who can actually purchase a vehicle are agreeing to loan conditions and average payments that have never been seen before.

Over the past ten years, the typical loan period for a new car has risen substantially and is currently at 70 months. Currently, a loan with a length of 72 months is the most popular, with an 84-month loan not too far behind. In fact, more than 73% of brand-new auto loans had terms greater than 60 months in the first quarter of 2022, up over 33 percentage points from the same period in 2010.

According to the formal “20/4/10 rule,” you should put 20% down, have a loan that lasts no more than four years, and keep your total monthly automobile budget to no more than 10% of your take-home pay. The truth is that this rule is not only being disregarded, but it is also out of date given how expensive new and secondhand cars are nowadays. This is why, if you can afford it, Edmunds advises getting a 60-month car loan. Although a lengthier loan may have more manageable monthly payments, there are several disadvantages that we’ll cover later.

In fact, the tendency is worse for loans for secondhand cars, where just over 80% of loan terms were longer than 60 months. In the first quarter of 2022, 72 months was the most popular loan length for used cars. Even though individuals finance used cars for around $8,500 less than they do new cars, the loan is paid off in roughly the same period of time.

Melinda Zabritski, senior director of automotive financial solutions at Experian, stated that consumers are up against two challenges. Their goal is to obtain a favorable interest rate and a manageable monthly payment. However, a five-year loan’s monthly payment is frequently too high for them, so they finance for a longer term even if it will cost them more in the end, according to Zabritski.

Is there anything else to getting a car loan for six or seven years than just a cheaper monthly payment? No. Actually, there are a lot of reasons not to select a lengthy auto loan. Let’s look more closely.

car exhaustion

Before taking out a lengthy loan, many people fail to take this into account. When our automobiles are brand-new, we adore them, but as soon as the romance wears off, we are anxious to trade them in for something new.

According to Wards Auto, the typical ownership period for a new car is 8.4 years (100.8 months). Given that a used car should only be owned for a shorter period of time than a new one, let’s calculate a 7-year ownership period. Despite what people claim to do when purchasing a vehicle, Americans do not often drive it “until the wheels fall off.”

Take those typical ownership periods and examine the effects of different loan conditions.

Let’s start with new cars. Pretend you have a 72-month auto loan and you start to feel the want to upgrade around the 100-month mark. Only two years and four months will pass without a car payment.

If you took out an 84-month loan and decided you didn’t want your automobile after six years, you would be forced to make a year’s worth of payments on a vehicle you were eager to sell. Rolling the remaining months of the loan into your next automobile purchase is an option if you truly need to get rid of the car.

But that’s almost always a bad idea because it creates a longer loan commitment and higher monthly payments for the next car.

Let’s now examine secondhand cars: Consider purchasing a used car that is three years old with a 72-month loan, which is what most people do. And after approximately seven years, if you’re like most people, you’ll get sick of the car. Only a year will have passed since you stopped making automobile payments. And if you decide to keep it, you’ll be driving a nine- or ten-year-old car.

Ivan Drury, senior manager of insights at Edmunds, said: “That’s risky business when you consider wear-and-tear.” You run a higher chance of adding negative equity to your subsequent auto loan.

Higher interest costs

Another justification for sticking with a 60-month loan is higher interest rates. You will pay more interest on the loan the longer the period, both in terms of the rate itself and the ongoing finance costs. Here are the figures when a 60-month loan is contrasted with a 72-month loan.

In the first quarter of 2022, the average loan for a new car was $39,340, with a 60-month term and an average interest rate of 5.2%. The total finance charges throughout the loan’s term would be $5,420, which translates into a hefty monthly payment of $746. It is simple to understand why someone would select a lengthier loan.

Compare that to a 72-month lease on a car. Longer loans typically have higher interest rates than shorter loans. The rate is averaging at 5.4% in early 2022, per Edmunds data.

The monthly payment for our new car, which has a loan amount of $39,340, would be around $641 throughout the course of the loan’s 72 months, as well as $6,804 in finance fees. It is understandable why someone might feel at ease taking on the longer loan in exchange for the cheaper installments.

But suppose this customer decided an 84-month loan would help them lower their monthly payment even further. A $563 monthly payment would be required. Up until you see the financing charges, which total $7,990 over the course of the loan, it seems like a significant improvement over 60 months. Over the course of the loan, that adds up to $2,570 extra, yet 34% of new-car purchasers are willing to make that concession.

Your monthly payment would be $559 if you got a used automobile with a 72-month loan term for the typical financed price of $30,830. From the standpoint of monthly payments, it appears to be a success. For used autos, however, interest rates are somewhat higher, and a rate of 9.2% is very typical.

Longer loans require more years of repayment, which extends the time it takes to accumulate equity in the vehicle. The more options you have to sell it or trade it in, the quicker you can reach equity.

How to determine the right term length

Consider the length of the loan term in proportion to the cost of the automobile and your financial status when choosing your auto loan. A longer loan term will result in a cheaper monthly payment, but if you can afford a higher loan payment or don’t mind driving a less costly car, it might not be the best option.

Before buying a car, it’s crucial to think about your finances and how much you can spend on the transaction and maintenance. Before going car shopping, be prequalified for an auto loan at your bank or credit union.

To find the right term length for your car loan, follow these steps: 

1. Determine your budget. This should be your monthly budget and how much you want to pay for the car itself. Consider whether your financial situation is likely to change and factor that in. 
2. Prequalify with at least three lenders. Shopping around can help you qualify for a lower interest rate. Working with your local credit union could afford you better payments, especially if you have an existing relationship. 
3. Compare the total interest. Take your prequalification results and plug them into an auto loan calculator to see how much you will pay per month and how much interest you would be paying overall. 
4. Make a decision. Consider both the monthly payment and the overall cost when deciding which loan term is best suited for your needs. 

Long-term versus short-term auto loans

While a lengthier loan will allow you to purchase a more expensive vehicle, it will cost you more in interest over the course of the loan. Consequently, even though the monthly payment would be less, the total cost will be higher.

On the other hand, a shorter auto loan offers lower interest rates but a greater monthly payment. You can have trouble making those payments if your budget is off track or if your income suddenly changes.

There is no ideal loan duration for every driver, so weigh the advantages and disadvantages of each before approving the purchase of your next vehicle.

Pros and cons of a long-term auto loan

If your budget cannot accommodate a higher monthly payment, a long-term loan is a fantastic option. Your monthly payment will be cheaper, which may make it simpler for you to buy a more expensive automobile.

However, you will end up paying more in total interest with a lengthier auto loan. By selecting a longer-term, you may wind up paying well over a thousand dollars extra. A longer-term loan also raises your chance of going into negative equity or owing more money than the car is worth. This situation can make selling or trading in the car more challenging.

Pros amd cons of a short-term auto loan

Whereas long-term auto loans may result in exorbitant interest payments, shorter terms result in overall interest payments that are lower. Additionally, it implies that you’ll get your car even sooner and in full. In addition, newer cars depreciate quickly in the first five years, making it unlikely that you would end up owing more on your car than it is worth for a considerable amount of time.

A short-term loan is a riskier option if your finances are tight. If you don’t have a substantial down payment, this is especially true. Avoid this by avoiding pricey vehicles that can put a strain on your finances.

When to consider a shorter loan term

There are a few justifications for approving a shorter loan. You won’t have a sizable loan to repay because you’ll pay off your loan earlier, allowing you to fully enjoy the car you’ve bought. When choosing the period of your loan, take into account these key considerations.

Fewer years to pay

Making payments for five to seven years may be necessary if the loan term is extended. Your automobile will be fully yours much sooner if you choose a shorter, three-year term. As a result, you’ll have more money each month to spend toward saving or paying off higher-interest debt.

Less likely to have a negative loan equity

You will have more freedom to make the adjustment if you need to sell your car or buy a new one. When you’re ready for a different vehicle, it will be simpler to switch out because you probably won’t have a balance that is higher than the value of your car.

Better resale value

Paying off your automobile sooner means it will be worth more after you’re through paying it off, similar to having a lesser probability of going into negative equity on your loan. This implies that you will be able to receive more for it than if you had to wait five or seven years if your circumstances change and you need to upgrade or just desire something new.

Conclusion

It’s critical to consider how much car you can actually afford. Consider how much you can pay for your automobile each month, including gas and insurance, in addition to the total amount of the loan.

The car of your dreams might not always be available on a shorter term. However, the compromise can be worthwhile if a less expensive version of the same model can save you from taking out a longer-term loan. Compare prices to find the best bargain, whether you choose a longer or shorter term.