Long-Term Car Financing

Oct 8, 2015 by

vehicle financingEverybody on the planet who sells something spends lots of time dreaming up ways to persuade you to buy more of whatever they’re selling. The real specialists are “marketing professionals” or “brand managers.” Procter & Gamble pays huge money to a woman or guy to “brand manage” the Swiffer. This person’s job description reduces to: persuade more people to spend more money on Swiffer! I can barely imagine a less personally satisfying way to spend a career, but hey—that’s just me. 🙂

Vehicle Selling Tool: Long-Term Financing

The vehicle manufacturers naturally employ marketers with the same mission: persuade people to buy more cars and spend more when they do buy a car. A clever and effective tool these folks have rolled out over the past several years is very long-term vehicle financing.

You might remember when 48 months was the longest term loan you could get when financing a car. Now loans of 60, 72, even 96 months are common. In another sad illustration of the poor state of consumer personal finance education, these long-term loan offers work because they exploit the way that many people judge whether they can afford something, which is: can I cover the monthly payment? Of course that’s a terrible way to judge whether a high-buck purchase is affordable, but unfortunately that’s how many people think. And they’re encouraged to think that way by realtors, mortgage lenders, car salespeople, and everyone else who benefits from the sale of big ticket items.

Long-term financing benefits car manufacturers in two ways:

  1. Many consumers will buy a costlier vehicle if the monthly payment is about the same as a cheaper car financed over a shorter period.
  2. Many consumers will buy a new car sooner than otherwise if they perceive the monthly payment as affordable.

Consumers have been trained to think in terms of a monthly payment, not the total, long-term cost of an item.

We can all “afford” Teslas if financed over a long enough period, right?

How Much Does Long-Term Vehicle Financing Cost?

When you’re considering vehicle financing options, think about the total, long-term cost of the vehicle. This table illustrates what I mean for a new, $20,000 car purchase.

car loan cost

The monthly payment column makes plain the brilliance of this marketing strategy. By extending financing from 36 months to 96 months, the monthly payment is cut by nearly 60% from $577 to $246. How many consumers would look at the $246, 96-month payment and think, “wow—I didn’t think I could afford a new, $20,000 car, but I can!” Lots. And that is why long-term vehicle financing exists.

Car sellers may disclose, but only at document signing, surely not during the selling process (that would be bad for business), the nearly $3,000 in additional interest cost the buyer will pay by taking on a 96 instead of 36-month loan. Their $20,000 car really costs, in the end, $23,627.

Underwater on a Loan is Not a Happy Place to Be

There’s another big problem with long-term vehicle loans. The longer the loan term, the more likely the borrower will be underwater on the loan and for a longer period of time. Underwater means the outstanding loan balance is more than the car’s current market value.

When the 96-month borrower makes her first $246 payment, only $175 is going toward the $20,000 loan principal. At the end of the first year, the loan balance will be $17,855. According to Edmunds.com, a new car may depreciate by 20% in the first year. That means this $20,000 car is now worth $16,000—$1,855 less than the $17,855 loan balance. The vehicle owner is nearly $2,000 underwater on the loan.

What’s wrong with being underwater? If the owner needs or wants to sell the car, or it’s totaled in an accident or stolen, the owner will need to cough up the underwater amount—$1,855 in this example—to pay off the loan. Otherwise, expect the debt collector to call. And it’ll be tough to get a loan on another car until the old loan is repaid.

Judging What You Can Afford

When you’re looking to buy a car or anything else you have to finance, look at the total cost, including interest, not the monthly payment to judge how much you can afford.

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