How Long Should My Car Loan Be

When it comes time to be a new car, most people look at the price in terms of how it fits their monthly budget. Monthly budgeting has been especially important since the financial turmoil stemming from the subprime mortgage meltdown. It is perhaps because of this focus on the monthly budget that the average length of a car loan has increased over the past decade; whereas it was once unusual for a car loan to be longer than 5 years, the average car loan is now 5.5 years, according to data from Edmunds. Moreover, this same data shows that 38% of auto loans in 2012 had a term of 5.5 – 6 years, and 12% of the loans had terms of 6 – 7 years.

Longer loan terms allow the borrower to spread repayments over a longer period of time, which reduces the amount paid every month. However, by doing this, the borrowers ignore the cost of interest on the loan as well as the length of time it takes to pay off the loan. The fact is, the longer a loan is, the higher the interest rate. A quick search on bankrate.com shows that lenders are advertising a 60-month (5 year) loan for a new car at rates between 1.99% APR and 2.34% APR. The same site shows 72-month (6 year) loan for a new car advertised between 2.44% APR and 3.59% APR. This means that by taking a 72-month loan compared to a 60-month loan, a customer will pay a higher interest rate for a longer period, meaning that they pay more in interest charges over the life of the loan.

For example, let’s take a 60-month new car loan of $25,000 at a rate of 2.25% APR. My trusty Excel spreadsheet tells me that this is a monthly payment of $440.93 per month for 60 months. This is a total of $26,456.02 paid over 60 months on a $25,000 loan, with $1,456.02 in interest payments.

Let’s also look at a 72-month new car loan of $25,000 at a rate of 3.25% APR. By extending the term an additional year, the payments are now down to $382.64 per month for 72 months for “savings” of $58.29 per month. However, the 72 monthly payments of $382.64 come to a total of $27,550.40 paid on a $25,000 loan, for a total of $2,550.40 in interest payments; nearly twice the cost of the 60-month loan.

Another factor to consider is the risk of becoming “underwater” in your loan. Shorter loan terms allow you to gain equity faster, and reduce the risk of you owing more than the car is worth, should you decide to trade it in.

The moral of the story is that monthly budgets are important, but you need to look at the overall cost of a loan as well to make sure that is makes financial sense for you. On a related note, if you want a really low monthly payment without the risk of being caught underwater, you might want to consider leasing a vehicle. A lease allows you to borrow a vehicle for a period of time. Rather than paying to own the entire car, you merely pay for the time that you use the car. And when your lease is up, you have the option of either buying the car or just walking away. Leases generally have much lower monthly payments than even a long-term car loan, and carry none of the risk of being caught underwater.

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