Avoid Taking Auto Loans For More Than 5 Years – The Negative Equity Wave
There is a negative equity problem building within the U.S. auto industry. Negative equity is when you go to trade in your car for a new one but the outstanding balance on your car loan is GREATER than the value of your car. You have the option to either write a check for the remaining balance on the loan or “roll” the negative equity into your new car loan. More and more consumers are getting caught in this negative equity trap. Below is a chart of the negative equity trend over the past 10 years.
In 2010, 22% of new car buyers with trade-ins had negative equity when they went to go purchase a new car. In 2020, that number doubled to 44% (source Edmunds.com). The dollar amount of the negative equity also grew from an average of $3,746 in 2010 to $5,571 in 2020.
Your Car Is A Depreciating Asset
The first factor that is contributing to this trend is the simple fact that a car is a depreciating asset, meaning, it decreases in value over time. Since most people take a loan to buy a car, if the value of your car drops at a faster pace than the loan amount, when you go to trade in your car, you may find out that your car has a trade-in value of $5,000 but you still owe the bank $8,000 for the outstanding balance on your car loan. In these cases, you either have to come out of pocket for the $3,000 to payoff the car loan or some borrowers can roll the $3,000 into their new car loan which right out of gates put them in the same situation over the life of the next car.
Compare this to a mortgage on a house. A house, historically, appreciates in value over time, so you are paying down the loan, while at the same time, your house is increasing in value a little each year. The gap between the value of the asset and what you owe on the loan is called “wealth”. You are building wealth in that asset over time versus the downward spiral horse race between the value of your car and the amount due on the loan.
How Long Should You Take A Car Loan For?
When I’m consulting with younger professionals, I often advise them to stick to a 5-year car loan and not be tempted into a 6 or 7 year loan. The longer you stretch out the payments, the more “affordable” your car payment will be, but you also increase the risk of ending up in a negative equity situation when you go to turn in your car for a new one. In my opinion, one of the greatest contributors to this negative equity issue is the rise in popularity of 6 and 7 year car loan. Can’t afford the car payment on the car you want over a 5 year loan, no worries, just stretch out the term to 6 or 7 years so you can afford the monthly payment.
Let’s say the car you want to buy costs $40,000 and the interest rate on the auto loan is 3%. Here is the monthly loan payment on a 5 year loan versus a 7 year loan:
5 Year Loan Monthly Payment: $718.75
7 Year Loan Monthly Payment: $528.53
A good size difference in the payment but what happens if you decide to trade in your car anytime within the next 7 years, it increases your chances of ending up in a negative equity situation when you go to trade in your car. Also, when comparing the total interest that you would pay on the 5-year loan versus the 7 year loan, the 7 year car loan costs you another $1,271 in interest.
But Cars Last Longer Now……
The primary objection I get to this is “well cars last longer now than they did 10 years ago so it justifies taking out a 6 or 7 year car loan versus the traditional 5 year loan.” My response? I agree, cars do last longer than what they used to 10 years ago BUT you are forgetting the following life events which can put you in a negative equity scenario:
Not everyone keeps their car for 7+ years. It’s not uncommon for car owners to get bored with the car they have and want another one 3 – 5 years later. Within the first 3 years of buying your car that is when you have the greatest negative equity because your car depreciates by a lot within those first few years, and the loan balance does not decrease by a proportionate amount because a larger portion of your payments are going toward interest at the onset of the loan.
Something breaks on the car, you are out of the warrantee period, and you worry that new problems are going to continue to surface, so you decide to buy a new car earlier than expected.
Change in the size of your family (more kids)
You move to a different climate. You need a car for snow or would prefer a convertible for down south
You move to a major city and no longer need a car
You get in an accident and total your car before the loan is paid off
The moral of the story is this, it’s difficult to determine what is going to happen next year, let alone what’s going to happen over the next 7 years, the longer the car loan, the greater the risk that a life event will take place that will put you in a negative equity position.
The Negative Equity Snowball
A common solution to the negative equity problem is just to roll the negative equity into your next car loan. If that negative equity keeps building up car, after car, after car, at some point you hit a wall, and the bank will no longer lend you the amount needed to buy the new car and absorb the negative equity amount within the new car loan.
Payoff Your Car Loan
Too many people think it’s normal to just always have a car loan, so they dismiss the benefit of taking a 5-year car loan, paying it off in 5 years, and then owning the car for another 2 to 3 years without a car payment, not only did you save a bunch of interest but now you have extra income to pay down debt, increase retirement savings, or build up your savings.
Short Term Pain for Long Term Gain
Rarely is the best financial decision, the easiest one to make. Taking a 5-year car loan instead of a 6-year loan will result in a higher monthly car payment which will eat into your take home pay, but you will thank yourself down the road when you go to trade in your current car and you have equity in your current car to use toward the next down payment as opposed to having to deal with headaches that negative equity brings to the table.
Post COVID Problem
Unfortunately, we could see this problem get worse over the next 7 years due to the rapid rise in the price of automobiles in the U.S. post COVID due to the supply shortages. When people trade in their cars they are getting a higher value for their trade in which is helping them to avoid a negative equity situation now but they are simultaneously purchasing a new car at an inflated price, which could cause more people to end up in a negative equity event when the price of cars normalizes, the car is worth far less than what they paid for it, and they still have a sizable outstanding loan against the vehicle.
About Michael……...
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
