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A long-term loan with low payments or a short-term loan with high payments? We examine which is the best approach to financing your next car.
Determining “Affordability”
Dave Ramsey will tell you there is indeed an optimal car loan length: zero months, as in, don’t get a car loan and simply pay cash every time you purchase a car. And while this might be sound advice for the most frugal or financially precarious, it’s also not practical for a large percentage of people. While wanting the latest in automotive technology might seem frivolous, modern safety equipment offer a significant upside over what cars were equipped with even just ten years ago. Plus, if you’ve got cash on hand, there’s the question of whether investing it is more profitable for you, in the long run, versus the interest you’d be paying on a car loan.
All that is to say, for most of us, car loans are just part and parcel of purchasing a new car. The question becomes, if you’re going to be taking a loan / financing your purchase, what is a reasonable length for that loan? In recent years, lenders have been extending the length of loans to accommodate more expensive vehicles while keeping monthly payments low enough for buyers to “afford.” So, what’s the problem?
The Dangers of Long-Term Loans
It’s not just the Dave Ramsey’s of the world who preach caution in the case of extended auto loans. First, there’s the basic problem of larger loans with longer terms, extending now to 72, 84, and even sometimes 96 months. The longer the car loan length, the more interest that is paid overtime on the same principle. And this is to say nothing of the higher rates that longer loans tend to carry. Due to a higher risk of delinquency, long-term loans come with higher interest rates which means not just paying interest for longer, but also paying more of it, too.
There’s also the danger of getting “underwater” on your loan, or in financial parlance, falling into negative equity. If you’re paying a premium for your new car and take out a long-term loan to cover it, it is possible the car can depreciate more quickly than you’re paying down the principle on your loan. At some point you will owe more than the car is actually worth, i.e. “underwater”. That’s not just a problem when it comes time to trade in the car, it’s also bad news if you happened to get into an accident and the insurer is then paying you out for a vehicle worth less than your outstanding loan. This makes it especially important to get gap insurance if you do go with a long-term loan.
Taking the Middle Path
Longer loans can offer more flexibility for buyers to pay back their loans at a comfortable rate. Sure, you could pay down a long-term loan aggressively, say putting down 30-50% more than your minimum monthly payment. I’m sure you’ve also heard that the best-laid plans of mice and men often go awry.
Back in the real world, taking a short-term loan, that is one that is 60 months or shorter, is the wisest way to finance a car. You can manage this in a few different ways. First, you can take out a smaller loan on either a more affordable new car or a used car, thereby getting a low monthly payment similar to that of a long-term loan. Or you can go with a higher monthly payment, accepting that’s just the price you’re willing to pay for your fancy new whip. Another option is to make a larger down payment. Even if saving the full $41,000-dollar average for a new car isn’t in the cards, that doesn’t mean you shouldn’t save some cash and make a hefty down payment as part of your financing. This last approach is a great safeguard against negative equity and can actually provide positive equity from the get-go.
Whichever path you take, our best advice is to pay down your principle with a vengeance. One benefit of taking a short-term loan with higher payments, beyond the lower interest rate, is that you’ll feel greater pressure to pay off your loan early. It’s easy, if your payments are low, to procrastinate and pay only the minimum monthly payment, month after month and year after year. But if that minimum payment is substantially higher, the more likely you are to devote additional resources to paying off your auto loan as quickly as you can.
Dave Ramsey is right about one thing; all auto loans, and the interest therein, raise the cost of your vehicle purchase. So, if you are financing, be judicious about your car loan length and endeavor to pay it back ASAP.
