CNBC reports that the U.S. economy is increasingly “K-shaped” — with wealthier Americans adding to their wealth with rising home values and lucrative stock market returns.
In contrast, lower- and middle-income households have been hit hard by higher inflation, with these consumers looking for ways to save elsewhere (1).
This economic divide hows up even in the way these groups are responding to higher car prices.
The Kelley Blue Book reports that the average cost of a new car hit $50,080 in September, the first time ever average prices exceeded the $50,000 mark (2).
As a result of rising prices, those who borrow to buy a new car are taking on longer loans than ever.
In fact, the average loan length is now 69 months, with 22% of loans hitting a record-high 84-months (3), according to data from automotive research firm Edmunds (4). A 60-month term is the firm’s recommended cap, but that’s become less realistic for many buyers who are struggling to budget amid the rising cost of living.
While longer loan terms may seem attractive for buyers looking to keep their transportation costs within their budget, they can also end up costing more in the long run. Here is a breakdown of the true cost of a longer car loan terms and tips on paying off your loan faster.
“While there are many affordable options out there, many price-conscious buyers are choosing to stay on the sidelines or cruising in the used-vehicle market,” said Erin Keating, Cox Automotive executive analyst, according to the CNBC (1).
“Today’s auto market is being driven by wealthier households who have access to capital, good loan rates and are propping up the higher end of the market.”
Edmunds reports that the previous “20/4/10” rule for buying a car no longer applies (4).
The old rule was:
Make a 20% down payment
Stick to a four years maximum for your loan term
Spend no more than 10% of your take-home pay on your car costs
But with prices soaring, a 5-year, or 60-month loan is the new standard.
Here is how the math breaks down:
If you spend the average $50,000 for a new car with a 10% down payment and assuming the current average loan rate of 7%, the costs break down like this:
A 48-month loan term gets you a $1,078 monthly payment and you spend $6,724 total in interest
A 60-month loan term gets you a $891 monthly payment and you spend $8,463 total in interest
An 84-month loan term gets you a $679 monthly payment and you spend $12,050 in total interest
In other words, the longest loan term costs you $5,326 more in interest than the 48-month option — almost double. Edmunds also reports that those who opt for longer loans have higher rates of car fatigue and often opt to roll the remaining months of the loan into their next car purchase.
This creates an even deeper cycle of debt, as well as maximizing the interest you eventually pay for your car loan. With higher interest rates across the board for loans, this can suck real money out of your budget that could be funneled to savings or investments.
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Knowing that a longer loan term can cost you thousands down the line, how can you decide the best way to budget for a new car?
While the old “20/4/10” rule may not work for your budget, try to keep your costs as low as possible by crunching the numbers and seeing how much interest you’ll pay over the life of your loan.
You should also plan to use any windfalls like a bonus or tax refund towards your loan payment — just be sure that your additional payments will be applied against the principal loan balance rather than your interest.
You can also pay off your car loan faster by making biweekly payments instead of a monthly payment. For example, a biweekly payment on a $10,000 auto loan with a 7% interest rate would see you save $478 on interest and pay off the loan 13 months faster (5).
You could also opt to round up your car payments to the next $50 or $100 to help you chip away at your balance faster. Any extra payments you can make to help you get out of debt sooner will also help you save even more money on interest payments.
If your budget doesn’t allow for a term as close to 60 months as possible, you may want to delay buying a car til you’re in a better financial position to do so — and if you have that option. Cox Automotive and Moody’s Analytics report that some buyers are delaying their purchase in the hope that car prices and interest rates will eventually fall, leaving them easier terms in the future for their car loan.
What if you’ve already signed a long term for an auto loan?
Here are a couple of tips for how to pay it off faster. First, consider refinancing your loan.
A shorter repayment term will save on interest charges and even help you get a better rate if your credit score has improved since you first applied for the loan. LendingTree warns that there may be upfront fees to refinance, so be sure you will save enough on interest charges to make up for these added costs (3).
If you’re tackling your car loan as part of a larger plan to become debt free, you may want to calculate how much you’ll spend on debt and interest payments by opting to repay through the avalanche method vs. the snowball method.
In other words, you may find paying off your highest interest debt first will save you the most money vs. paying off the smallest debt first to gain momentum.
Whichever you choose, reworking your budget to find extra money to pay off your loans will ensure you have greater peace of mind in the future.
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CNBC (1); Kelley Blue Book (2); Edmunds (3; 4); Lending Tree (5)
This article provides information only and should not be construed as advice. It is provided without warranty of any kind.
