Car Loans: How Long Should They Be?

Choosing the right loan length requires balancing the total cost of the loan and the monthly cost.

Choosing the right loan length requires balancing the total cost of the loan and the monthly cost.

A new car is one of the most expensive purchases a consumer will make. Buying a car usually requires making payments for years, and making that kind of commitment could call for personal sacrifices.

"A car purchase can change the way you will need to live the rest of your life," said Michael Rubin, author of "Beyond Paycheck to Paycheck."

Before agreeing to a long-term loan, Rubin says to make sure you understand what those payments will do to your overall budget, including your bills and savings goals. You should ask yourself whether you're prepared to make those sacrifices, as well as know how long you're prepared to do so.

The first thing you need to figure out is how long you plan on keeping the car. If you plan on replacing your car often, Rubin suggests getting a shorter loan — shorter than you plan to keep the car. That's because resale values for cars often fall quickly, so you could end up owing more than the car is worth when you go to sell it or trade it in.

Choosing the right loan length requires balancing the total cost of the loan and the monthly cost. Allison Vail, a spokeswoman for LendingTree.com, said the length of your loan will directly affect your interest rate.

"A shorter-term loan pays off the car faster and helps you pay less in overall interest costs," she said.

The flip side of that is that a short-term loan — say, three years — comes with monthly payments that are more expensive: For a $22,000 car financed at 5 percent, you'll pay around $659 a month over three years. Assuming the same financing rate — which Vail notes is unlikely — over a six-year loan you'd pay only $354 a month for the same car. By doubling the length of the loan, you trim your monthly payments by nearly half. But as Vail pointed out, doubling the length of a loan would likely mean getting a higher interest rate, so the loan will cost you more overall.

For instance, with 5 percent financing over three years, a $22,000 sedan ends up costing a total of $23,737. If you double that length to six years and keep the same interest rate, the amount owed is $25,510. By doubling the length of the loan, you'll pay more than twice as much in interest: $3,510 in interest payments versus $1,737.

There is, however, an acceptable limit to how long a vehicle loan should be. John Ulzheimer, president of Consumer Education for Credit.com, says a common mistake many consumers make is focusing too much on individual payments.

"It doesn't mean it's more affordable, it just means you can afford the monthly payments," Ulzheimer said.

Keep in mind that you'll probably have a higher interest rate on a six-year loan than you would on a three-year loan. Using the same example as above, that $22,000 loan for six years at 7 percent interest (which is still a conservative estimate) would cost you $5,000 in interest — nearly three times what the three-year, 5 percent loan would cost you.

Long-term loans might work for people who have a healthy income now but are unsure about their future. People in this situation should get the longest loan possible at the lowest interest rate, Ulzheimer said.

"That way you can pay off the loan aggressively, but if you lose your job or other emergencies arise you will have some leeway," Ulzheimer said.

According to Art Spinella, general manager of CNW Marketing Research, the average loan length in 2009 was in the mid-60-month range, down from an average of about 70 months in 2008.

Spinella said that, in today's tough credit market, many lenders are looking for larger down payments and shorter loans.

With average credit scores hovering around a relatively high 710, it can be difficult for a consumer to get a really long-term loan (more than 60 months) coupled with a good interest rate without having superb credit.

Even with tightened credit markets, seven- and eight-year car loans are gaining in popularity. According to the Wall Street Journal, seven-year loans represent a small but increasing fraction of the retail lending industry — Toyota Financial, GMAC Financial and Ford Motor Credit all offer seven-year loans.

Ulzheimer said he thinks such loans are a bad idea.

"If you have to finance something for over 60 months, you shouldn't be buying a car, or you should be getting into something cheaper," he said.

The problem with very long loans is that they often carry very high interest, and by the time payments end your vehicle's resale value will be small and its useful life expectancy may be nearing its end. According to R. L. Polk & Co., the average car's life is 9.4 years; with trucks, it's just 7.6 years. Because of that, Ulzheimer says, seven- to eight-year loans don't make a lot of sense.

If you choose to finance a car for longer than 60 months, choose a car with good reliability and resale value. According to Consumer Reports, the brands with the highest reliability ratings overall are Honda, Subaru and Toyota. According to Kelley Blue Book, Honda has the best resale value overall.

© Cars.com 7/9/10
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