TODAY WE ARE TALKING ABOUT AUTO LOANS. WHY?
According to a recent report from the credit reporting agency Experian, the length of auto loans continues to get longer and longer. According to the data, the average loan length for new cars is now 69 months – 6 years and 9 months – and loans of 85 months or more represented 1.5 percent of all new-car loans! Longer loan terms combined with higher interest rates could spell financial trouble for consumers. This morning, I want to walk through what is causing this trend and remind our listeners what to keep in mind if they are considering buying a car.
HOW MUCH LONGER ARE AUTO LOANS NOW THAN SAY, A DECADE AGO?
About a third of auto loans for new vehicles taken in the first half of 2019 had terms of longer than six years, according to Experian. A decade ago, that number was less than 10%. That increase is cause for concern.
WHY CAN’T AMERICANS AFFORD AUTO LOANS WITH SHORTER TERMS?
Three main factors are at play here. First, according to Experian, the size of the average auto loan has grown by about a third over the past decade to $32,119 for a new car. This has partially been driven by a big jump in the number of options available in most new cars. The technology that goes into the multimedia displays, sound systems, and additional safety features is not inexpensive, and it has driven the price of even the base models up.
At the same time as cars are getting more expensive, wage growth has not kept pace. Adjusted for inflation, wage growth has been less than stellar over the past few decades for most American families. That has meant many buyers do not have the room in their budget to buy new cars using the more traditional 3, 4, or 5-year loans.
Finally, tastes have changed. Gone are the days of a family sedan and a station wagon. Now, Americans prefer SUVs and crossover models, both of which are more expensive. Together, these factors have meant consumers are signing up for bigger, longer-lasting loans in order to purchase a car.
SO THESE LONG LENGTHS ARE IN RESPONSE TO AFFORDABILITY?
Precisely. According to a “Wall Street Journal” piece last week, “just 18% of American households had enough liquid assets to cover the cost of a new car.” And if the U.S. consumers try to stick to the traditional auto loan length, they are unlikely to find a car. In the same article, we saw the hard math: to stick to a four-year loan term, put 20% down and keep payments under 10% of gross income, the median income U.S. household could afford a car worth $18,390. Compare that to the average loan of around $32,000, and the gap is clear.
As a result, auto companies and dealers have changed their approach to financing to keep cars, SUVs and trucks moving off their lots. To put people in the cars they wanted with monthly payments they could afford, they extended loan lengths. Loan terms loans between 73 and 84 months emerged in 2013 and 2014 when interest rates were very low. But these loans can put consumers behind the financial eight ball in the long run, Tom.
WHY ARE THESE LOANS SO RISKY?
The biggest risk is owing more on your car than it is worth. With a longer loan period, you pay more in interest, and see more depreciation. To stay in a positive equity position, you need to ensure the principal balance is always in line with the vehicle’s value. This is hard to do over long periods with new cars, and it makes used cars especially risky. If a car is 3 years old, it has already lost around 44% of its value at 13% annual depreciation. If you take out a 6-year loan, you will be making payments on a 9-year-old car, and you are almost certainly going to have negative equity. If you trade it in, you could be in a position where you get into a vicious cycle of adding that previous negative equity to your next auto loan. In fact, nearly a third of car owners are rolling over debt from a previous car into their new loans, which is really scary, Tom.
HOW DO WE AVOID GETTING STUCK WITH AUTO DEBT?
Simply put, you should not be buying a car you cannot afford. Do not look at what you can spend each month. Instead, look at the total payment, including interest, for the entirety of the loan, with all applicable taxes and fees. If you can pay it off in under 5 years and afford the monthly payments, you can consider it. If not, ask yourself whether you’d be better off spending less on a car and saving or investing the difference.
Second, avoid getting caught in an underwater equity position. Whether it is long financing, or using a sub-prime loan, make sure you do not end up owing more than the value of your vehicle.
If you keep these two rules in mind, they will serve you well. New cars may be nice, but long-term financial health is much more important.