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Today, more than ever, borrowers have many options when it comes to financing their cars, including the length of their loan terms.
For a long time, three- or five-year car loans were the norm. In recent years, six- and seven-year car loans have experienced a surge in popularity. According to the Consumer Financial Protection Bureau, 42% of auto loans funded in 2017 carried a term of six years or more, compared to just 26% in 2009.
There are a couple of possible benefits to getting longer-term loans, depending on your financial situation. But there are also notable risks that may make alternative options or a five-year car loan a better choice.
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Benefits of a longer car loan term
You’ll make smaller monthly payments
A longer loan term can mean smaller monthly payments. For example, say you’re financing a $30,000 new-car purchase over five years and you’re doing so at a 3% APR with no down payment in a state with no sales tax. Your monthly payments would be $539 each. If you were to opt for a seven-year loan, all other loan terms being the same, you’d make monthly payments of $396 — a difference of $143 per month.
But keep in mind that with a longer term, you’re making more payments. For this example, you’d make 84 monthly payments on the seven-year loan versus the 60 payments with the five-year term. You’ll also pay more in interest overall with the longer loan.
It may free up cash you can use to pay off more-expensive debt
Let’s say you’re deciding between a five-year car loan and a seven-year car loan. The smaller monthly payment that comes with the longer loan term may free up resources to pay down other high-interest debt more quickly. But this only makes sense if the interest rate on your debt is significantly higher than your car loan’s interest rate.
Say you’re buying that new car at 3% APR, and you also happen to have a credit card balance of $10,000 with a 20% APR. If you choose the seven-year loan term on the car and apply the extra $143 that you’d have available each month to your credit card debt, you could save on interest overall. Because even though you’d end up paying more interest on the longer-term loan than on the shorter, you’d be able to pay off your higher-interest credit card debt in less time, potentially saving you more interest in the end.
Risks with a six- or seven-year loan
You’ll likely have heftier interest costs
A six- or seven-year car loan will likely leave you with a larger total interest payment than a loan term of five years or less. Take the $30,000, 3% APR car loan (with no down payment and no sales tax): You’d pay $2,344 in interest over a five-year term. But with a seven-year loan at the same rate, you’d pay $3,301 in interest.
You’ll likely have repair costs while paying down the loan
If your loan term is longer than five years, you could be making car payments long after your warranty has expired. Many new cars come with basic warranties that last four or five years and powertrain warranties that span five or six years. A car’s repair costs tend to increase with age, and if your warranty expires before the loan is paid off, you may face repair bills while still making monthly car payments.
A handful of automakers do offer slightly longer warranties. Kia, Mitsubishi, Hyundai and Genesis offer 10-year/100,000-mile powertrain coverage. And many Volkswagen vehicles come with a six-year/72,000-mile comprehensive warranty.
It can put you in a negative equity cycle, which can create a bad financial situation
According to IHS Markit, Americans keep their cars for an average of 79 months before trading them in. If you stick to this average and have a seven-year car loan, you could still owe five months’ worth of payments when you trade in your vehicle for a new one. A car dealer will usually be able to roll this amount into your new auto loan, but it will increase your monthly payment. Ultimately, this may place you in a negative equity cycle.
What is negative equity?
If you owe more on a secured loan than the property is worth, you’re said to have negative equity. This is also called being upside down or underwater on a loan.
A car’s value can decrease by 20% to 30% in the first year. Once interest is factored in, this depreciation may mean that you temporarily owe more on the loan than the car is worth. With a longer loan term, you build equity more slowly. This means you could end up with negative equity for a much longer time period than if you had chosen a shorter loan term.
Negative equity in your car can make financial hardship even worse. If you need to sell your car to cover an emergency expense, negative equity can make it impossible to turn a profit, because the vehicle will be worth less than the amount you owe on the loan. In this situation, you’d need to find another source of cash, which could result in more debt.
Negative equity could also create a serious problem if your car is totaled in a collision. Many standard auto insurance policies will not cover repairs if they cost more than the value of your car. Instead, they’ll pay you its “book” value. If you owe more on your loan than the car is worth, you could find yourself making payments on a wrecked car.Learn more: How to get out of a car loan when you’re upside down
Before getting a six- or seven-year car loan, look into less-costly alternatives like leasing, buying an affordable used car, or delaying your purchase until you have money saved for a larger down payment. Going this route may help lower your monthly payment without the risks that can come with longer loan terms.