Is a 7-Year Auto Loan a Good Idea?

There’s a hot new trend sweeping the auto industry and it has nothing to do with autonomous or electric vehicles. It’s the seven-year (or more) auto loan, and it’s making pricey vehicles feel more affordable than ever before by stretching payments over a longer timeframe.

A couple forces are fueling the trend. For starters, new vehicles are getting more expensive as they increasingly become four-wheeled technology platforms that sport a host of cameras, blind-spot sensors, WiFi and even autonomous safety features. That’s pushed the average price of a new car to $37,185, which is out of reach for many Americans if they finance on the old-fashioned five-year-loan. A longer loan can reduce the monthly payment, which can make the price tag easier to stomach.

These days, dealers also make more money financing and insuring the vehicle than the vehicle sale itself. That gives dealers incentives to inflate the size of that loan by upselling you on warranties, theft protection, insurance and other add-ons. That larger loan is a little more appealing if, again, you stretch those payments out over a longer period. And it’s working: The percent of new vehicle loans with terms longer than seven years has risen 38 percent year-over-year.

However, there are few things to consider before signing the bottom line on a seven-year auto loan.

YOU NEED TO QUALIFY FOR LOW RATES

Dealers get you in the door by advertising incredibly low interest rates for vehicle financing, say a 0.9 annual percentage rate (APR). That’s a really good rate for a loan, but they aren’t giving that rate to everyone. Typically, only the highest-qualified borrowers are eligible for that rate (think a credit score of 700 or higher). But if you can get a low rate on a long-term loan, it might make sense from a cash-flow perspective. If you’re planning to pay $30,000 in cash for a vehicle, for example, you could instead make a $10,000 down payment and finance the rest to keep that $20,000 in cash on hand to save, invest or spend on something else.

However, if your credit isn’t excellent, you’re probably going to pay a much higher interest rate — especially if you stretch the loan out past 60 months. New car buyers, on average, are taking out $32,000 auto loans with a 68-month term at a 6.16 percent rate. That amounts to a monthly payment of about $554, according to Experian. That means you’re actually paying nearly $38,000 over the life of the loan.

Quick tip: If you’re in the market for a new vehicle, go in armed with your credit score from another agency. Dealers aren’t required to show you the report they run when they check your credit. If something seems off — your score is 20 points, or more, lower than your report — that could be a red flag and worth asking a few more questions before taking next steps.

YOU COULD BE ‘UNDERWATER’ FOR A LONG TIME

If you take out an seven-year loan with no down payment, you’ll be paying for a car that’s not worth the loan you are paying off immediately after you drive off the lot. A car can lose 20 percent or more of its original value within the first year, which means you could still have loan debt even if you sell the car. According to Edmunds, a third of car owners are underwater on their auto loans.

On top of it all, seven years is a long time to own a car. In the meantime, you’ll also be paying maintenance costs as many parts won’t outlast the loan.

Quick tip: One way to combat this is to drop at least 20 percent of the sale price as a down payment. That basically accounts for the vehicle’s first-year of depreciation (20 percent) once you drive it off the lot. Or, you can purchase gap insurance to account for the vehicle’s depreciation and pay off the loan, in case you’re in an accident. Fortunately, your vehicle’s value falls at a slower pace as time goes on, which increases the odds you’ll be able to pay off the loan and perhaps have leftover cash if you sell it.

IT NEEDS TO FIT YOUR BUDGET, REGARDLESS OF FINANCING

The allure of longer loan terms is that a car that may have been out of your budget appears more affordable. The Wall Street Journal, in an article about longer auto loan terms, highlighted one buyer’s budgeting snafu. Deven Jones and his girlfriend financed a new Honda Accord with a 72-month loan that cost more than $500 per month. When they split up, that entire monthly payment fell to him and consumed 25 percent of his monthly budget. That put him in a tight spot, especially with his other debts.

Quick tip: Think about how much you earn and your monthly spending. There are committed expenses, or certain things you pay for each month because they are essential — think housing, food, and health care. While you can’t really control the fact that these are necessities, you can control how much you pay. Transportation is one of those committed expenses, and we typically recommend keeping transportation costs to around 10 percent of your monthly income — no matter how it’s financed.