The problem with taking a one-size-fits-all approach to a topic like the correct car loan length is that it doesn’t take into account, well, you. In other words, your age, monthly budget, creditworthiness, etc. is different from your neighbor’s situation. If your credit score is 750, you have a completely different perspective on borrowing money than your neighbor’s who has a 600 credit score.
We aim to provide general advice to the average borrower. But even if you’re at the extreme of the credit score bell curve (above 800 or below 500), you can still benefit from the tips provided here.
Causes water to be muddy, the current auto market is affected by the worldwide shortage of microchips and the breakdown of the supply chain. According to analysts at Cox Automotive (the parent company of Autotrader), by the fall of 2021, the average price of a new car was 2% more than the manufacturer’s suggested retail price. Prices have gone up even more. In other words, buyers paid more than the automakers were asking for the car because demand outpaces supply.
Dealing with the borrowing strategy that works best for you in this volatile auto market is more difficult than it has ever been.
Why buy a car with debt?
Let’s face it, most of us can’t afford to pay cash for a new or a used car. According to the credit experts at Experian EXPGY,
Less than 16% of new car purchases in the last quarter of 2021 were cash transactions. For 84% of us, that means borrowing money from the lender and paying it back month after month until the loan is paid off in full.
Experian reports that the average new car loan amount during the fourth quarter of 2021 was $39,721, with an average monthly payment of $644. The loan amount has increased by 12% over the same period in 2020. The average loan term in the fourth quarter of 2021 was nearly 70 months, with an average interest rate of 3.86%.
Financing is not as important for most used car buyers. Statistics show that nearly 61% of used car sales in the last quarter of 2021 were cash transactions. During that period, the average amount funded on used cars was $27,291 at 8.2% interest. This funding amount is more than $4,600 year-over-year increase. The average term of used car loans was 67.4 months at $488 per month.
However, very few of us are average. Once we have decided to buy a new car and have borrowed money to do so, we need to know the length (term) of the loan that best fits our budget.
So if you are wondering what the typical term of a car loan is and what terms you should choose, this article should answer most of your questions:
Plus: Used cars cost more than new? Here’s what happens and where to find deals.
How long can I finance the car?
You may be able to find lenders who will customize the terms of your car loan, but this is an exception rather than a standard. The most common terms for auto loans are 24, 36, 48, 60, 72 and 84 months. Few lenders will even make it to 96 months. However, again, this is the exception rather than the rule.
What is 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. Well, the problem is solved, right? What do you decide? The math seems to suggest that you should use the longer run and the lower payout. However, there is actually more than that.
What are the disadvantages of long-term loans?
When you get a car loan of any duration, do not buy the car; The lender does. In other words, the lender pays the seller for the car. Your monthly payments are made to the lender. You don’t own the car until you pay the lender all the money you borrowed. The lender does not lend you money out of the goodness of his heart. By your signed promise to repay the lender, you also agree to pay a fee (the interest rate) for using that money.
When you sign the paperwork at the merchant, you will be tempted to accept longer loan terms. There’s a reason for this: monthly payments become lower when extended for a longer period. At first, this may seem like more cash in your pocket, which is a good thing.
But the longer the loan term, the more you will have to pay for using the lender’s money. So, even though your monthly payments will be lower for a 72-month loan than for a 48-month loan, you’ll end up paying more for the car. Moreover, many lenders raise the interest rate as the term of the loan increases. You can pay a higher interest rate for a 36-month loan than for a 24-month loan.
For example, using Autotrader’s Monthly Car Payments Calculator, financing $20,000 for a car at 4.5% for 36 months would 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 will spend $2,859 in interest over the life of the loan. That’s an extra $1,441 you’ll pay for that car. And that is if the interest rate does not rise itself in the long run.
Read: Used electric cars: How to navigate the narrow market for used electric cars like the Nissan Leaf and Chevy Volt
There is more to consider
Let’s say you’re willing to incur the extra cost of a 72-month loan to score lower monthly payments. Paying higher fees for using the money isn’t the only drawback of a long-term loan. Here are two other issues to consider.
First, when using a long-term loan, you will not have any equity in the car until very close to the payment date. This means that you will owe more than the value of the car until the last few payments. It won’t be of any use as a trade-in if you want to buy another car. The lender will roll over the difference between its value and the amount you owe on your next car loan.
Second, most new car warranties expire long before the car is five or six years old. With a long-term loan, you may find yourself paying for expensive repairs to a car that you still make monthly payments on. Neither of these issues makes financial sense to you or your family.
We seeIt’s a tight market for first-time car buyers: 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 interest 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-like monthly payments on a non-luxury vehicle, like a Honda Accord or Toyota Camry, even if you know that’s the smartest financial decision.
As another example, refer to the monthly car payments calculator. If you finance $20,000 to purchase a car at 4.5% interest for 36 months, the payment will be $595. Financing the same amount with the same interest for 60 months works out to a monthly payment of $373.
We all face limitations with monthly budgets and often have no choice but to spread out the cost of a vehicle. However, avoid loans longer than 48 months if you can.
How do interest rates affect the terms of a car loan?
In addition to the term of the loan, your credit history and other factors can affect the effective interest rate. According to Experian, interest rates for new cars in the fourth quarter of 2021 averaged 3.86% and 8.21% for use. Below is an example of the difference in the monthly payment and the total interest cost for two different interest rates.
Let’s pay another visit to Autotrader’s monthly car payments calculator with $20,000 to fund it. Financing this 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 to $377 per month with a total interest cost of $2,645.
Getting the best interest rate you deserve can save you money, regardless of the term of the loan.
Is short term or long term loan better?
In the end, our advice is simple: when you buy a car and are thinking about getting a car loan, choose the shortest term and the best possible interest rate. This option may not be the most attractive idea, considering that it will increase your monthly payments. Plus, it may limit the type of car you can afford. But in the future, you will thank yourself when you saved thousands of benefits and paid for your car years before you even thought about it.
This story originally ran Autotrader.com.