Recession Rescue: Tackle Your Auto Loan Debt

Feb. 26, 2008 — -- With constant talk about the sour housing market and subprime financing woes, little has been mentioned about another trend in financing which is baring its equally vicious fangs — car loans.

The issue? The length of the average car loan has soared in recent years resulting in an increased debt load for consumers.

In fact, almost 45 percent of new-car buyers are opting for a loan that is longer than six years. Some car manufacturers are even offering eight-year loans on their luxury lines — and the longer the loan, the greater the price tag for the car.

Mellody, you are not a proponent of long-term auto loans. Why?

A car is the one asset, which loses value the moment it becomes yours and you put the key in the ignition. In fact, a car loses 15 percent to 20 percent of its value in just the first year. Given that interest rates are historically low for car loans — rates hovered near 18 percent in the early 1980s, compared to 7 percent today — stretching out the loan over a longer period does not seem like a bad idea on the surface, especially since your monthly payment will likely be relatively low and manageable.

The reality, though, is this monthly payment stays with you for a long time and you end up paying significantly more for the car than the amount you originally agreed to. For example, if you take out car loan for $15,000 and finance it over a six-year period at an interest rate of about 7 percent, you would pay $255 each month. At the end of the six-year loan, you would have paid a total of $18,361 — $3,361 more!

Also, you say the longer the loan, the greater the chance you could be upside down on your car? What does that mean?

As I said, the moment you drive a car, it immediately loses value. Basically, upside down means you owe more on your car than it is actually worth. This is bad news for a car owner who is having trouble making the monthly payments and needs to sell the car or is interested in trading in the vehicle for another vehicle because even if you get rid of the car, you will still have the debt. And, rolling that debt into a new auto loan is a recipe for only greater debt.

What advice would you give someone who finds themselves upside down?

If you can afford to, I would recommend you pay more than your monthly payment in order to pay off your loan sooner. In some cases, there are prepayment penalties though, so call your loan provider before you do this. If you can afford it, you also may consider refinancing your loan for a shorter term and potentially a lower interest rate. With a shorter term, your monthly payment would rise, but the value of your car would also be higher by the time it was paid off — which bodes well if you want to trade it in or sell it.

How about for those in the market to buy a new car, besides avoiding long-term financing terms, what else would you recommend?

Well, first, like when shopping for a house, be realistic about what you can afford and be sure you are able to pay a reasonable down payment. Also, while many auto manufacturers have related financing companies, shop around for car loans before you hit the dealer lots. You would never think to buy a car without first test driving it — take the same track with regard to financing it. You need to do the math on not just the monthly payment, but on what you would owe over the life of the loan.

Interesting stat: Consumer Reports says the average life expectancy of a new vehicle these days is around eight years or 150,000 miles.