How Long Should a Car Loan Be?

Although the post-pandemic inventory of new cars has stabilized, buyers' financing costs still exceed the maximum possible. According to Edmunds data, the average new car payment through November 2023 increased to $734. Compared to the first quarter of 2022, when we last reported on this data, that represents an increase of roughly 13%.

The increase is due to growing interest rates and a trend among consumers to favour more expensive trucks and SUVs. Rates have increased gradually from 4.4% in February 2022 to 7.4% in November 2023.

Shorter car loans are another factor contributing to higher monthly car payments. Most new car loans, or roughly 64% of those financed through a dealer, have terms between 67 and 84 months, but since 2019, the number of shorter-term loans has more than doubled. 48-month loans rose from less than 7% in 2019 to over 14%.

Rates are generally lower for shorter terms, and buyers finance less (about $30,000) for shorter terms. Even with roughly 4% interest rates, the average loan payment between 31 and 48 months is still $775, unlike the expected increase in 2023.

What is the limit of excess?

The traditional "20/4/10 rule" of auto financing stipulates that you should have a loan with a maximum term of four years, put down 20% of the total cost, and keep your monthly car budget below 10% of your take-home pay. But in actuality, this rule needs to be updated and considered, given how costly both new and used cars are these days. Because of this, Edmunds suggests, if you can afford it, a 60-month auto loan. Although the monthly payment on a longer loan might be more agreeable, there are several disadvantages, which we'll go over later.

The trend is actually worse for used car loans. In 2023, the mean duration of a used car loan was 70 months, as opposed to 67 months in 2019. In the first quarter of 2022, a used car's most popular loan duration was 72 months. People finance used vehicles for about $10,000 less than they do new cars, but it still takes them about the same amount of time to pay off the loan.

According to Melinda Zabritski, senior director of solutions consulting at Experian, "Consumers are battling two things." They aim for a fair monthly payment and a favourable interest rate. However, Zabritski noted that a five-year loan frequently has a monthly payment that is too high for them, so they wind up financing for a longer term even though it will cost them more in the long run.

Is there any advantage to a six—or seven-year auto loan other than a smaller monthly payment? No. Actually, there are many reasons not to go with a long-term auto loan. Let's investigate more closely.

Automobile Exhaustion

Many people don't think about this before taking out a long-term loan. When our cars are new, we fall in love with them, but when the novelty wears off, we want to trade them in for something new.

Americans typically own new cars for eight years, but because used cars are older, people tend to own them for shorter periods. Nevertheless, despite the post-COVID inventory crunch, inflation, and higher interest rates, the allure of the "new car smell" endures.

Using those average ownership durations, let's examine the effects of different loan terms.

First, brand-new automobiles: Suppose you have a 72-month auto loan, and around the typical 100-month mark, you start to feel the need to buy a new car. You will be car-free for a mere two years and four months. Should you opt for an extended 84-month loan and become dissatisfied with your vehicle within five or six years, you would be left with a year's worth of payments for a car you were eager to sell. Another option, if you were really desperate to get rid of the car, would be to roll over the remaining loan months into your next car purchase. According to Edmunds's data, some people might act this way.

When a car is traded in for a new one, its average age is 5.5 years. However, using November 2023 as an example, roughly 55% of the cars traded had less than five years on them. Ivan Drury, director of insights at Edmunds, notes that this includes a spike in trade-ins at about the two-year mark, indicating a shift in an earlier spike that used to occur at about three years. This type of trade-in almost always results in a longer loan commitment and higher monthly payments on the subsequent vehicle, making it a bad idea.

Let's now examine secondhand cars: Let's say, like most people, you purchase a used car that is three years old and pay for it with a 72-month loan. You won't have gotten to enjoy a year without auto payments if, after roughly seven years, you grow bored with the vehicle. If you decide to keep it, you will be stuck with a nine—to ten-year-old car.

"That's risky business when you consider wear-and-tear," says Drury. "You could be at greater risk of rolling the negative equity into your next car loan."

Compare these circumstances to those of purchasers who select five-year loans. They have been free of auto payments for just over three years at the average ownership point of 100 months, and they are free to sell the car anytime they choose.

Increased interest expenses

Another argument in favour of a 60-month loan is higher interest rates. You will pay more interest on the loan over its length, both in terms of the interest rate and the accumulated finance charges.

As of 2023, the typical loan amount for a new car is about $40,000, with a term of 69 months and an interest rate of 7.2%. That works out to an average monthly payment of $734, a significant chunk of money in most household budgets. It's easy to see why someone would opt for a longer loan. What is the total interest paid over the life of the loan? Almost $9,000.

Contrast that with an 84-month auto loan. The interest rate would be higher, which is typical for longer loans. According to Edmunds data, the rate averages about 9.4% near the end of 2023. The monthly payment for an 84-month loan for our new car, with a $40,000 loan amount, would be approximately $650. It is not smaller than the shorter loan but still a sizable portion. However, extending the loan results in a staggering amount that accounts for nearly nine additional monthly payments: almost $5,800 throughout the loan.

Longer loans require longer payback terms, which prolongs the time it takes to accrue equity in the vehicle. The quicker you reach equity, the more options you have for selling or trading in equity.

Negative equity

A new car usually loses 15% to 20% of its value in its first year. You typically have "negative equity" in a car at the start of a loan because you owe more on it than it's worth because of that depreciation. It's also called "underwater" or "upside down." You further sink deeper when you make an inadequate down payment. And if you choose a longer loan term, you go even further. The reason for this is the extra finance charges.

The car you purchased and your down payment will determine how long you can accrue equity. You want equity because it offers you options. If your other bills pile up or you lose your job, you can sell the car if you have equity. Negative equity, however, restricts your options in case of financial difficulty. Additionally, it ties you down if you grow tired of your car before it's paid off. Only the car's worth—not what you owe—will be paid to you by a buyer. The remaining loan balance is unavoidable for you.

Similarly, your insurance provider will only reimburse you for the car's market value at the time of the collision if you are in an accident and it is totalled. The balance owed will be paid out of pocket unless you have a gap or new-car replacement insurance.

Reduced value at resale

Another reason to avoid very long auto loans is resale value. A five-year-old car is more valuable and desirable in the used car market than a seven-year-old if you intend to sell it when it is paid off. A vehicle that is five years old has lost roughly 48% of its initial cost. A car that is 7 years old has lost approximately 59% of its value. Stated differently, the $40,000 new car in our example will be valued at about $20,800 after five years. After seven years, it falls to $16,400.

You will always receive a higher price for the five-year-old car from a dealership. It's still a strong contender to be certified pre-owned (CPO) at that age, giving the dealer a more valuable car to sell.

However, a seven-year-old car is no longer eligible for CPO. Most automakers won't consider older cars—more than five years old—into consideration. Similarly, a car with too many miles on it will not be eligible for a CPO program. That implies that the car's trade-in value will be significantly lower.

Substitutes for extended loans

Suppose you would like to purchase a new car but find the monthly payments for the typical five-year loan too high. That might indicate that you're buying items that are beyond your budget. Check out the "What can I afford?" calculator from Edmunds. You begin by selecting your desired monthly payment, and after a few clicks, vehicles within your budget will be displayed.

Consider purchasing a used, older vehicle. Used cars have higher interest rates, but because they are less expensive, there is less to finance, so the payments should be smaller. Just remember the conditions of the loan. Finding a good deal in the used car market in 2023 may be difficult due to its continued inflation resulting from general inflation and recovering supply constraints. By the end of 2023, the average payment for a used car was $562.

Last piece of advice

Knowing your monthly car payment limit is crucial, but it shouldn't be your only indicator of a quality auto loan. Examine every figure in the sales contract to ensure you understand exactly how much you pay for the vehicle.