Research of the Week: Revealing the Risk of Long Term Auto Loans

Long term financing lowers payments, but presents a higher risk of default

Each week, Consolidated Credit searches for financial research that can help you deal with your debt and budget. This week…

The interesting study

The Consumer Financial Protection Bureau (CFPB) released a report in November that investigates trends in auto loan financing. The report shows a marked increase in the number of long term auto loans taken out by borrowers.

The big result

Roughly 42% of the auto loans financed within the past year carried a term of six years or more. That’s a notable increase from the 26% of long term car loans found in 2009. A six-year term equates to 72 monthly payments needed to pay off a vehicle.

The fascinating details

Auto loans are currently the third largest source of debt in America, after mortgages and student loans. There are more than 100 million loans currently in repayment, totaling over $1 trillion. More than 90% of American households have at least one vehicle. Consumers use auto loans for 86% purchase of new vehicles and 53% of used vehicle.

 

Weighing total costs when financing vehicles using long term auto loans

The trouble with auto loan financing revealed by the report is the high rates of default found with these loans.

  • 8% of borrowers who use long term auto loans default, compared to just 4% of short term auto loan borrowers

Essentially this means that if you have an auto loan with a term of six years or more, you are twice as likely to default. As more and more consumers use these loans, experts predict that auto loan default rates will continue to rise.

Higher default rates could also be rooted in who uses longer term loans and for what purpose:

  • Consumers with low credit scores are more likely to use these loans.
    • Borrowers who opt for a longer term have an average credit score of 674, which is 39 points lower than borrowers using 5-year loans
  • Long-term loans tend to be for larger amounts.
    • The average loan amount for a 6-year loan is $25,300
    • By contrast, the average loan amount for a 5-year loan is $20,100
    • If you go up to a 7-year loan, the average amount is $32,200

Both of these points make sense when you consider the relation of loan term to monthly payment obligation. A longer term lowers your monthly payments. If you have bad credit, you qualify for a loan at a higher interest rate. So, often times these borrowers extend the term to offset higher interest charges. The same is true of larger loan amounts.

What you can do

“Long term auto loans help lower your payments, but they aren’t always a smart choice for financing,” explains Gary Herman, President of Consolidated Credit. “Consider that the average driver only keeps a new car for 71.4 months. So, basically borrowers would want to sell their cars before they finish paying off one of these longer-term loans.”

Most experts recommend that you should limit the term for most non-mortgage financing to 60 payments (5 years) or less. That’s a reasonable amount of time to repay most financing outside of a mortgage. It helps keep interest charges minimized and avoids a situation where you wear a vehicle out before you pay it off.

“Instead of opting for a longer-term auto loan where you have a higher risk of default, there are other ways to keep monthly payments low,” Herman explains. “For instance, if you can increase your credit score before you apply for the loan it will lower the interest rate. You can also take a few months to save up to make a larger down payment. The more you pay upfront, the less you need to finance.”

Herman also warns against accepting dealership financing at face value. Special offers like 0% down payments may seem like a smart financial choice, but often cost more money over the life of the loan. In many cases, you may be better off securing financing through a bank or credit union, which offer better loans but without incentives.

For more tips on auto loans, visit Consolidated Credit’s guide to Managing Auto Loan Debt. And if you’re purchasing a new or used vehicle, use the free Car Payment Calculator on our Miss Money Bee blog.

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