Taking a 7-Year Car Loan May Not Be a Good Idea
One of the main considerations when applying for a car loan is its term or the period of time over which you repay your loan. Typically, car loan terms range from one to seven years. The long-term plans of around 6 or 7 years translate into low monthly repayments. However, getting a long-term car loan may not be a smart move.
Long-Term Car Loan is On the Rise
More and more people are taking out car loans with longer payment periods. The average term for car financing is now five years and 6 months but loans that last to 6 and 7 years (72 and 84 months) are also becoming increasingly common.
This trend has made buying cars, including expensive ones, seem affordable. In order to offer the lowest monthly payments without lowering the loan balance or the interest rate of a car loan, lenders lengthen its term. With low monthly payments, car buyers like you can easily keep up, especially if you have a regular salary or income.
However, there are many downsides to taking a 6 or 7-year car loan.
1. You will be paying more in interest over time.
The longer the loan, the more interest you’ll pay. Car loans usually have a fixed interest rate. As a result, you cannot make extra payments from time to time or pay out the loan early unless you pay the early termination fee.
The average interest rate for a car loan in Australia is around 6%. If you loan a $30,000 car over seven years, you will end up paying $36,813 for the vehicle.
If you don’t have a full-time paycheck to cover payments, paying that 6% interest for seven years can be difficult.
2. Your car will be worth a small percentage of what you paid for.
Any car loses its monetary value the moment it is sold. The depreciation is also quick starting at around 10% after driving it off the dealer’s lot and another 10 to 20% by the end of the first year. After that, the car depreciates yearly around 15% to 25%. By the fifth year, which is normally the end of the warranty period, it loses around 60% of its value. After seven years, the once expensive vehicle could be worth as little as 20% of its purchase price.
Unfortunately, your loan will not get paid down as quickly as your vehicle depreciates. In seven years, you would be owing more money than what your car is worth. If it gets stolen or totalled in an accident, you would still need to pay the excess balance.
Upside Down (a.k.a. Underwater) Loan
When you owe your lender more than the worth of your car, you’ve gone “upside down” or “underwater” on your loan. This is a precarious financial position to be in. In case you lose your job and need money to pay off an emergency expense, you won’t get much from selling your depreciated car. Worst, you’d still need to pay off the loan balance even when you lose the vehicle.
3. You can get stuck in a debt trap.
Like most car owners, you’d probably get bored with your vehicle in less than seven years and get a new one through trade-in or car refinance.
The old car that you want to trade-in has equity. This is the difference between the value of your car and the amount you owed on the loan. If your car is worth $10,000 and you still owe $4,000 on the loan, you’ll have $6,000 of equity in your car. The lender will pay off the $4,000 loan balance while $6,000 will go toward the new vehicle.
However, the trade-in may work out unfavourably if you are upside down on a car loan. Some lenders will add your trade-in shortfall to your new car-loan balance, putting you even more upside down on your next vehicle.
Getting a new car loan to pay off your existing loan obligation will extend your car loan term to several years. Although the process can help you keep your vehicle and lower your monthly payments, you will also pay more interest over time.
When Does a Long-Term Car Loan Make Sense?
A long-term car loan may work out in your favour if you have a high credit score. You’re more likely to get a special deal with an interest rate close to 0% from automakers. You can also avail car financing from lenders at very low interest rates of around 1.50 to 2.30%.
This is in contrast to having a bad credit score where auto loans can get very expensive with interest rates of 14% or higher. In this case, it’s not a smart idea to have your loan term around 7 or longer as it would mean prolonging the agony of paying the high interest rate.
Choosing between a long-term or short-term car loan should be based on your individual circumstances. If you want to have low monthly repayments and in no hurry to achieve other financial milestones, you can go for a long-term loan plan. On the other hand, if you can afford high monthly repayments, it’s best to stick to a short-term loan to avoid paying significantly more in interest.