Auto loans have long been a part of everyday life. While Americans have healthy appetites for automobiles, the smorgasbord of slick wheels, shiny paint and promised luxury may be too rich for our wallets.
Many of us are skipping the starters and heading straight to the dessert table full of luxury trucks, brand-name SUVs and loaded crossovers far pricier than more modest sedans.
In 2015, we bought more of them than ever. Truck, SUV and crossover sales shot up 15 percent in 2015, compared to 2014. Most of those sweet rides were bought with auto loans.
Car Buyer Behavior
Driving one of those high-end status symbols off the dealer's lot is all too easy. Paying for it, however, is not.
Second-quarter 2015 loan figures from Experian Automotive, a leading car loan financier, prove that automotive financial industry players are tracking your every buying move:
- Buyers financed 85.8 percent of new vehicle purchases and 55.5 percent of used vehicle purchases with a loan.
- The average loan was $28,524, with an average payment of $483 a month.
- The most common loan term for new car purchases was 61-72 months; 41 percent of buyers stretched car terms to as long as 6 years.
- The next-highest bracket was 73 to 84 months (that's 6 to 7 years) with 28.8 percent of new vehicles financed.
- The average interest rate was 4.81 percent.
- Leases accounted for nearly a third (31.38 percent) of all new financing.
- Nearly half (48.48 percent) of leases financed were for buyers in the prime credit category, meaning people with credit scores between 661 and 780. About half that (23.36 percent) were leases for super prime credit score owners, those with scores of 781 to 850.
Game Of Finance Over Value
From age 16 on, the ability to navigate to and from school, college, work, home and everywhere in between is a prime determiner of independence and undeniably an American rite of passage. Many areas in our country still lack convenient, affordable public transportation, making a car a necessity.
However, when you're determining how valuable that car will be, Kelley Blue Book cautions that on average:
- In the first year, new cars lose 36 percent of their purchase price value.
- By the third year, new cars have lost 52 percent of their purchase price value.
- After 5 years, a new car has lost 60 percent of its purchase price value.
Lets translate that into dollars and cents, using the average car loan figure of $28,524:
- After the first year, your car will be worth $18,255; after 3 years, $13,690; and after 5 years, $11,409.
- Currently, on a 5-year loan at 3-percent interest, your payments will be about $513 a month, and at term's end, you'll have paid over $2,228 in interest alone, bringing your cost to nearly $31,000 for a vehicle that is worth only a third of what you paid for it.
Buying a car is not an investment, it is an expense. The whole purpose of an investment by definition is "to gain profitable returns, as interest, income, or appreciation in value." Compare that to the acts involved in an expenditure: to use up, pay out, disburse or spend - to consume.
Financing Is Often A Financial Necessity
With car prices averaging nearly $30,000, most people cannot simply pay cash and drive away. Even if you have a portion of the price, a car loan may make better sense. If you have stellar credit and can finance at 0 percent, the question becomes "why wouldn't I borrow?"
If you can snag an interest rate that is significantly less than what your money is earning in a savings vehicle, why would you want to deplete appreciating savings for a depreciating car?
Usually, however, scenarios are far grimmer, with potential car buyers making financial mistakes with long-term repercussions and regrets.
The 3 Worst Ways To Finance Your New Car
If you want to enjoy your ride without regrets, here are 3 mistakes to avoid:
De-Investing In Your Home
You may be tempted to use a home equity line of credit (HELOC) to finance your car, but don't do it. Using a HELOC may seem like a flexible, easy solution. But each benefit comes with an afterthought:
- Yes, you can shorten or lengthen your term to 10, 15 or even 20 years, but what will your car be worth after a decade or 2?
- Yes, you can pay interest only and use the tax advantage of interest paid, but the loan balance will remain although your car will only be worth a small fraction of its original price.
- Yes, you could split the cost of a car between a HELOC and a regular car loan, but then you'll have 2 concurrent principal-plus-interest payments instead of 1.
More important, HELOCs apply a variable rate of interest to your balance, and they don't have interest caps. What may seem a bargain rate today may escalate monthly and derail your original repayment plans. Plus, the HELOC balance counts against your home's value.
If you want to refinance your home, you may find yourself unable to do so, due to bank requirements for PMI (private mortgage insurance). If your home equity sinks to less than 20 percent of your home's appraised value, the bank will tack on PMI, raising your payment.
If you want to sell, you may owe more than you can clear on the current real estate market. Most HELOCs currently are charging prime plus 3 or 4 percent, putting your interest rate between 6 and 8 percent if you have a high credit score. If the prime rate goes up, your interest rate will, too.
Make sure you know the true, realistic value of your property before you write that check for $30,000 or more.
Tapping Your 401(k)
You need to remember your 401(k) account's purpose: It's money you're saving for your retirement. As long as you contribute an equal amount, most employers match your contributions (6 percent is a common figure). Continuing deposits, interest on your contribution and employer matching funds all make your balance grow, unless you make a withdrawal. Many rules govern that 401(k):
- You can only withdraw half of your vested amount up to $50,000, whichever is less.
- Repayment interest terms are usually the prime rate plus a percentage point or 2.
- The maximum repayment term is 5 years. However, you must settle the loan before leaving your job or within 60 days of departure, or your 401(k) loan will become a withdrawal. You'll owe taxes on the balance, and you'll lose 10 percent as an early withdrawal penalty if you're younger than 59½.
Meanwhile, if you use your 401(k), you not only borrow pretax dollars from yourself but also deflate future earnings. Some employers won't allow regular pretax contributions while your loan is outstanding.
During that period, you'll also lose employer matching funds, your savings-based tax advantage and the account's financial growth. Before you use your 401(k) for an expenditure like buying a car, plug some figures into a 401(k) loan calculator to find out how much growth you might miss out on.
Merrily Rolling Along In Debt
Many folks just never, ever get ahead in the car game and instead fall further and further behind, focused not on the financial bottom line, but on the car glam factor. They are never, ever without a hefty car payment. The 2 prime causes are rolling debt forward and leasing.
Rolling Debt Forward: When what you owe on your car exceeds what the vehicle is worth, your financial situation is "upside-down." According to Debt.org, in 2014, "27% of car sales were made to people with negative equity who owed an average $4,257 on their loans." Debt.org also cautions that "cars lose at least 20% of their value as soon as you drive them off the lot."
If you decide to trade in the vehicle on a new one, or if you have an accident that totals the vehicle, know that car dealership trade-in value as well as auto insurance reimbursement value may be considerably less than what you still owe on the car. However, you will remain responsible for settling the loan.
While a dealer or loan officer may be willing to forward that debt into a new rollover loan, it will increase your payments and most likely your interest rate, further compounding the problem. Your new car may already be upside-down and depreciating while your debt just grew. Roll car debt forward another time, and you may find yourself in a financially untenable position.
Leasing Fiascos: While businesses often lease high-use automobiles to benefit from tax advantages and associated maintenance plans, the average person is looking at quite a different situation:
- Lease payments are based on a vehicle's depreciation over the lease term plus interest, taxes and fees. Your monthly "loan payment" is actually a "depreciation payment," almost akin to monthly damages for vehicle use. It's the difference between capitalized cost (the car's value when you begin the lease) and residual value (its worth at lease end).
- You don't own the vehicle. At the end of the term, you must turn it in unless you decide to buy it. The dealership will want at least residual value plus an option-to-buy fee that's often $300 to $600.
- Even though you won't own the car, to initiate the lease, you'll have to pay taxes, tags and registration as well as a down payment, a security deposit, the first month's payment and possibly several other dealer-initiated fees.
- Because miles driven depreciate a vehicle, leases carry mileage limitations, usually 12,000 to 15,000 miles per year. If you drive more, you'll have to negotiate higher payments or pay a mileage penalty at lease end, usually about $0.15 per mile. Drive 10,000 miles over your limit, and it could cost an extra $1,500 at term end.
- Early termination fees make shortening a lease financially onerous.
- You will have to pay for any damages or modifications to the vehicle at term's end.
Perhaps worst of all, at term's end, you'll either have to refinance the vehicle to buy it or walk away from one vehicle only to do it all over again with another one, which you won't own either. As long as you lease, you will never escape the monthly payments and the lease initiation costs and fees every 2 to 4 years.
Paying For The Car Et Al
image courtesy of Tesla Motors
Cars are not one-off expenditures; costs extend well beyond the original car purchase transaction. Some states have annual personal property taxes or sticker inspections that can require repairs. You'll have to insure your car, maintain it, keep it in fuel and maybe even pay to park it.
Dealers and auto manufacturers make big money off optional features, which can easily add 20% or even 30% to a vehicle's price tag. You won't be able to finance all those extras, so choose wisely. Treat your vehicle like any other expenditure, not an investment.
A cheap alternative to buying a new car is to purchase a used car using a low interest credit card with a long introductory low APR period on purchases. Although you won't be able to buy a very expensive car, due to the limited line of credit, if you can pay off your balance before the intro APR period ends, you won't have to pay any interest on the loan.
If you use a credit card that lets you earn cash back on your spending, you can get back 1% or even 2% of what you spend on your car. Buying a $5,000 used car can get you $50 cash back with a 1% cash back credit card, or $100 with a 2% card.