Picture of Christopher A. Hopkins, CFA

Christopher A. Hopkins, CFA

Avoiding the car loan debt trap

For 85% of Americans, the purchase of a new vehicle means taking on monthly payments. But for too many buyers, auto loans are turning into debt traps from which escape can be difficult. Today 1 in 6 new car purchasers who finance are committing to monthly payments of $1,000 or more, with some contracts extending to 7 or even 8 years.

With both the prices of cars and interest rates rising, it is even more important to shop carefully for financing and to avoid committing to a loan that locks you into a perpetual cycle of debt.

The need for vehicle financing has grown with the relative cost of new cars. In 1925, a brand-new Model T cost $250, about $4,000 in today’s dollars. As vehicles have become more powerful, dependable, and sophisticated, their cost after inflation has increased by a factor of 8, necessitating the use of ever more credit. Auto loans outstanding today total $1.55 trillion, rapidly closing on student loan debt as the number two consumer loan category after home mortgages. But unlike a house or an education, a car is a depreciating asset and financing over too long a period or at too high a rate is a wealth destroyer.

The advent of auto financing traces back over a hundred years. Henry Ford did not believe in credit but offered weekly payment program that amounted to a layaway plan: customers took delivery once the full price was deposited at the dealership. In 1919, General Motors established its own financing arm, GMAC (now Ally Financial), that allowed buyers to drive away with 35% down and the balance financed over one year. By the time Ford reluctantly established its own credit subsidiary in 1928, GM was rapidly gaining market share and eclipsed Ford in total sales the following year. By 1930, over 60% of new vehicles were bought on “time”.

During the post-WWII boom, demand for cars rocketed and financing options proliferated. A young Ford executive named Lee Iacocca introduced a clever scheme dubbed “$56 for ‘56” that allowed buyers to put down 20% on a new 1956 Ford and make monthly payments of $56 for three years. The move boosted sales and put a second car in many suburban garages, but also laid the groundwork for steadily escalating borrowing and longer repayment terms.

According to auto data firm Edmunds, the average new car loan now stretches over nearly 70 months. In addition, interest rates for prime borrowers have risen to 6.5% and can range as high as 12-14% for subprime buyers.

Even worse, longer loans doom many drivers to owing more than the car is worth when it’s time to chuck it. Edmunds reports that 17% of all new car loans involving a trade-in have negative equity, with the average buyer still owing $5,300 that gets wrapped into the new loan. Some folks are still paying for the last 2 cars with the loan on their third.

And sadly, borrowers with the lowest credit scores pay the highest rates and extend over the longest terms, creating a nearly inescapable cycle.

Since major purchases like a new car are much less frequent and more impactful for you than for the dealer, it pays to be well prepared before you take the first test drive.

Get pre-approved for your loan before stepping into the lot. This is important both for bargaining power on the sales floor and to possibly get a better offer from the dealer’s captive finance department.

Before applying, review your credit report. Your rate is highly dependent on your credit score, so you’ll want to correct any errors in your history at the 3 bureaus first. If you have any dings, you may want to delay your purchase for a few months while you focus on boosting your FICO score.

Apply to several lenders, including banks, credit unions, and even online lenders. Criteria for rates vary, so shop around. And don’t be afraid that the inquiries will hurt your FICO score. Most scoring models now treat all applications for the same purpose as one credit pull, and many don’t count car loan applications at all.

Determine your budget. Many buyers make the mistake of considering only the monthly payment and not the total cost of the loan. For the average new car loan of $40,000 at 6.5%, extending from a 5-year contract to 7 years means you’ll pay nearly $3,000 in additional interest, and likely portends negative equity on this car carrying over to your next one.

A good rule of thumb is to put down at least 20% and limit the monthly payment to 10% of take-home pay for no more than 60 months. If that is not doable, it’s probably time to lower expectations on the car you can afford.

Watch out for costly add-ons. Extended warranties, road hazard coverage, and additional products or features like service contracts or gap insurance may only seem to add a few bucks a month but mount up to hundreds or even thousands of dollars over the life of the contract. Ask yourself why the finance rep is so enthusiastic, and whether you really need them or can obtain them elsewhere.

The days of cheap financing are over, and falling into a car loan trap can have a lasting and unpleasant impact on your financial health. It pays to do your homework.

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