What is a sensible car loan term?

What is a sensible car loan term?

14 January 2019 Concept Car

When you’re looking to finance a vehicle, the car loan term is rarely on your mind. Sure, you’re aware that the duration of a loan can influence its overall costs. And you may also be aware that there are many different payment models, from quick three year long terms to far longer ones. And yet, in the overall picture, the price of the car and the monthly instalments always seem to be more important.

Is this a mistake? Should you be putting the loan term first? And: What is a sensible car loan term for you personally?

A big overview

To understand the impact of the topic better, we’ve put together this special. Here, you will find all of the relevant information. This will include:

  • Current car loan trends
  • The benefits and problems of longer and shorter terms
  • The differences between new and used cars
  • Alternative financing options
  • Techniques to bring the car loan term down.

As you’ll see, the car loan term is one of the most important variables at your disposal. If you’re doing it right, you can use it to twist a loan to your needs. Let’s now begin taking a look at how you can do that.

Table of Contents

What is actually considered a regular car loan term?
Terms are edging upwards
Why are car loan terms rising?
Loan term options
Is there anything wrong with a credit? The myth of paying cash
Short loan terms: The benefits
Long loan terms: The benefits
Long loan terms: The problems
What about used cars?
Summing it up I: Don’t trade time against quality
Summing it up II: When too long really is too long
How to bring the term down
Buy smart
Budgeting for car finance
Car loan terms at CCC

What is actually considered a regular car loan term?

Everyone is different. This is especially true when it comes to paying for your car. Still, over the past decade, there has been an undeniable trend in car finance. And it’s worrying many experts.

Car loan terms have become considerably longer. In fact, the average term is now considerably longer than what most consider healthy.

Most financial advisers will stress that the shorter the loan, the better. Ideally, you should have paid back your debt within three years.

Since that may be unrealistic for most, the usual number given is five years. Everything below that number is considered ‘fast’. Everything longer than that is considered ‘slow’.

Historical Blueprint

Historically speaking, even five years are a pretty long time. At least in the 50s, there seemed to be a tendency for car loan terms to get shorter rather than longer. Then regional branch manager Lee Iacocca developed a scheme that allowed Ford buyers to pay off their debt as fast as possible.

The concept was called ’56 for $56′. Its premise was simple: Get a brand new 1956 Ford and pay 20% upfront in return for a $56 monthly rate. This allowed consumers to pay off their loan within a mere three years.

The response was overwhelming. As Automotive News write in an excellent biography:

“It was so successful that his Philadelphia sales district shot from last to first place in the nation in units sold. “I became an overnight success,” Iacocca wrote in his autobiography. (…) Iacocca’s “56 for ’56” idea won him a promotion to district manager of Washington, D.C. Just four years later, in November 1960, Iacocca was elected a vice president and was appointed general manager of Ford Division.”

Terms are edging upwards

Taking this as a gauge, we’re today all paying back our loans way too slowly.

  • In 2010, the average car loan term was still 62 months. That’s pretty much exactly at the recommended limit of five years.
  • In 2015, that number had already crept up to 67 months.
  • Since then, car loan terms have lengthened even more. According to car advice site Clark, the current average car loan term is almost 70 months. This means it’s fast approaching the six year mark.

Although the average numbers are already quite revealing, they may be covering up the full extent of the problem. Plenty of affluent buyers are actually bringing down the average by taking out fast loans at excellent rates.

This creates the false impression that numbers have remained stable. In reality, the most popular loan category is currently 72 months. And there are even far longer car loan terms than that. Shockingly,. 84 month loan terms are quickly gaining in popularity. And there are even loans as long as 97 months!

Clearly then, we’re not just witnessing a change. We’re moving away from the ideals recommended by the experts with strident steps.

Why are car loan terms rising?

There are two main reasons why so many buyers are opting for a slow approach to car finance.

Firstly, a longer car loan term brings down your monthly payment. After all, you’re stretching out the same sum over a longer period. Even counting in the fact that a longer loan usually has a higher interest rate, this makes a 72 month loan more ‘affordable’ than a 60 month one.

Secondly, and this is a more recent phenomenon, car prices have gone up considerably. As car dealer magazine reported, the average price customers are willing to pay for a car in the UK went up by almost 40% between 2008 and 2018. In absolute numbers, this translates to a rise from £24,383 to £33,559.

One of the driving factors for the hike in car prices have been extras. More and more, advanced safety technology and formerly premium extras such as air conditioning are built into basic models. This has raised entry prices across the board.

But there’s more to the topic.

Markets are changing

As we reported in our major report on the history of the SUV, the car industry has used Sports Utility Vehicles to improve its dwindling profits. Whereas it was loosing money on many saloons and hatchbacks, SUVs have been a godsend. Many customers are willing to shell out many thousands of Pounds for the privilege of owning and driving one. This has played a vital part in transforming the industry.

Entry levels are a particularly sore point. According to recent data, the average costs of an entry level small car such as the Ford Fiesta went up from just under £10,000 to £12,715. This is already quite an incisive change. Over the same period, meanwhile, entry level SUV prices rose from £16,895 to almost £20,000.

Luxury for the masses

Matthew Freeman, a managing consultant at Cap HPI, summed up the issue perfectly:

“Many brands have moved to offer a more luxurious specification mix and eliminated their entry-level specifications. This is partly a response to PCP making cars more affordable and consumers moving up to more expensive models. It’s also worth noting that those base models were not especially desirable in the used market and had poor resale values. PCP has also shifted focus from the entry price to the monthly repayment, and having a model to advertise as “from £9,995” is no longer a priority – cars are more likely to be advertised on their monthly payment.”

Loan term options

Let’s take a look at the different term options at your disposal. Usually, the length of a car loan is indicated by a certain number of months, typically in 12 month increments.

So, this would mean that the most conventional loans have a term of

84, and
96 months.

Obviously, in theory, you could decide on any number between these stepping stones. In practise, you’re going to have to take your pick in increments of 12-months. This makes deciding on the right loan term for you a tricky business.

Let’s say that you want to keep your car loan term as low as possible. A 60 month loan is however a little bit too expensive for you. So even if you could afford to set the bar at 65 months, in practise your next best option is now to extend that to a full six years, making the loan considerably more expensive.

See how this, combined with steeply rising car prices, contributes to a gradual increase in the loan term?

Clearly, then, you’ll need to take your decision carefully.

Is there anything wrong with a credit? The myth of paying cash

Let it be said, however, that credit is not evil by default. There are many reasons, why taking up a loan can actually be quite healthy. Still, many passionately recommend against it.

In an online discussion, we recently read the following statement:

“If you couldn’t pay for the vehicle in full the day you drove it off the lot, sorry, you couldn’t afford it.”

It is a theme that keeps popping up in online guides to car finance: The only safe way to buy a car is to pay for it in cash. But is this actually true?

Surely, it can’t be argued that this is appealing. Once you’ve paid the car off in full, you run no risk of defaulting on a loan and potentially losing it again. Also, you are free to sell or exchange it anytime without dealing with the problem of being upside down on the loan or paying off remaining debt.

The experts are forgetting one thing, however.

Namely, how this impacts your financial flexibility. As finance service provider Fico correctly points out, by reverting to cash payment, “you may have to deplete your rainy-day funds. The risk of not having an adequate emergency fund may be one you are not willing to accept in exchange for paying cash.”

This is why paying for your car in cash is actually not a very good idea, unless it’s a very cheap vehicle. A much better option, which balances the benefits of cash payment with those of a credit is committing to a larger downpayment. We’ll get to that in a bit.

Short loan terms: The benefits

As we mentioned, most experts recommend short term loans. Why is this?

The shorter your loan, the less risk there is for the lender. We can just about predict the course of the economy for the next 2-3 years. Beyond that, however, it’s any body’s guess. And while your job may be safe for a few more months, you may well be on the dole in five years time. By reducing the length of the loan, you can keep these nasty surprises to a minimum.

As a result, the interest rate of a car loan tends to drop in sync with the loan term. So, the shorter the term, the less interest you’ll be paying and the lower your total car financing costs. This is why short loan terms equal a cheaper loan.

There’s another clear benefit to a shorter car loan term. Imagine you want or need to sell your car at the end of the term. Then a shorter loan term is going to give you a better price. A five year old car is simply more attractive than a seven or even eight year old one. Depending on the model you intend to buy, this can add up to several thousands of Pounds.

Short loan terms: The problems

At the same time, a short loan term is not without its drawbacks.

A shorter term may reduce the risk of unexpected shocks. On the other hand, if you do run into financial trouble over the length of the loan, the impact will be bigger. After all, you’re now paying more each month than with a slower loan. So if you are suddenly made redundant, keeping up with the higher monthly instalments will be harder.

Obviously, too, there will be less money at your disposal at the end of the month. This doesn’t just mean being able to eat out less. It also limits your ability to pay for repairs or petrol. In a worst case scenario, you could find yourself being unable to use your car for a lack of funds to repair it.

For many car buyers, these considerations are beyond the point, though. They are struggling to pay for a car and will accept any deal that reduces their monthly obligations. This is clearly the most obvious benefit of a longer car loan term.

Long loan terms: The benefits

The longer the term of your loan, the lower the monthly payment. This is obvious, since you’re simply spreading out the same amount of money over a longer period. This difference can be pretty substantial in some cases. In others, it can seem petty. Either way, even £50 more or less at the end of the month, can make the difference between being able to afford a car or not.

A longer loan term also has the added benefit that it protects you against sudden, unexpected expenses. If you’re paying more towards your loan, you’re leaving less money as a safety cushion in case of an emergency. With a longer loan term, you can put aside some money each month.

Obviously, having more money at your disposal means you’ll be able to enjoy your life more. Never underestimate this aspect! Driving a car doesn’t necessarily have to be ‘fun’. But it should not ruin your happiness either.

Long loan terms: The problems

That said, there’s a dark side to long car loan terms. For the lender, extending the length of the loan poses more risk. This sends interest rates up, making financing more expensive. How much more you’ll have to pay depends on a variety of factors, from your credit rating to the car in question and the exact conditions of the deal. You’ll need to do the maths here to determine whether the benefits are worth the extra cost.

To return to an argument we made before, a long term car loan can be more risky for you. If you run into serious longer term financial trouble within the loan term, you can end up having to default on the loan altogether. As a general rule

  • A shorter loan term protects you against bigger, more long-term financial shocks.
  • A longer loan term protects you against sudden, one-off financial shocks.

Being Upside Down

One potential issue with longer car loan terms is the danger of being upside down or ‘underwater’ on your loan. What does this mean?

Let’s say you’ve bought a car on credit and have agreed to a seven year loan term. After five years, you may still have to pay off around £10,000. But the market value of the car is now below that number – £8,000. So you’re actually owing your lender more than the vehicle is worth.

This can be a serious issue. If you intend to sell the car to replace it with another model, you will either have to roll over part of the loan to the next car or take up a new loan to pay off the outstanding debt. Also, if you total the car in an accident – even if you’re not at fault – the insurance payout will not be enough to cover the remaining loan payments either.

Several factors contribute to being upside down on a loan, most significantly depreciation. Long loan terms are decidedly part of the problem, too, however. By stretching out the length of the loan, you are paying off less each month. So the risk of the car losing its value faster than you are paying it off is very real.

Car Fatigue

Another reason in favour of shorter loan terms is that you may want to exchange your vehicle for another one sooner than you think. This tendency to desire a new car even if the current one is still working fine is referred to as ‘car fatigue’.

If you’ve only driven your car for 2 years, this may not seem like a problem to you. But try to remember for how long you owned your previous vehicles: Did you really take them as far as they could go? If you’re honest about this, you may find that you, too, have experienced car fatigue more than once.

In a feature about the US market, car pricing site Edmunds write:

“We love our cars when they are brand-new, but when the romance fades, we’re eager to trade them in for something else. The average length of ownership for a new car is about 6.5 years (79 months), according to IHS Markit. Used-car ownership averages 5.5 years (66 months). Americans do not tend to drive their cars until the wheels fall off, no matter what they say they’re going to do when they buy them.”

Car fatigue is a problem for any type of car loan. This is because it means you may still be in the red on the car when it sets in. It is particularly critical with a long term loan.

The remains of your car’s days

Let’s use an example provided by Edmunds to illustrate this point. Your current term is 72 months. Average ownership, as we’ve established, hovers around 79 months.

After six years, you’ll have paid off your loan. If you re-sell your car after 79 months, as the average driver does, you’ll only have driven loan-free for just over half a year. As Edmunds correctly asserts, you might have been better off leasing two cars for three years instead. Plus, you’ll enjoy the additional benefit of always driving a new vehicle.

Now, imagine, you’re taking out a 84 month loan. As we know, this is no longer an exotic option, but actually quite common. In this case, you’ll tire of your car on average almost half a year before you’ve fully paid it off. This is a lose-lose situation. Either you continue driving a car you don’t enjoy any more and then sell it off at a bad price. Or you exchange it straight away, at an even bigger loss.

Keeping the loan term as low as possible will mitigate this problem. If you pay off your car in 60 rather than 72 months, you’ll drive it loan-free for almost another two years before car fatigue sets in. Or you can sell it off while it’s still fairly new and get a much better deal.

What about used cars?

So far, we’ve mainly talked about new cars. Since second hand models tend to be considerably cheaper, you’d expect the average car loan term to be a lot shorter. If this were the case, it should reduce many of the problems we’ve discussed above.

Curiously, this is not the case. As data indicates, used car loans do tend to be shorter than new car loans, but not by a lot. Here, too, there is a palpable trend towards longer terms.

In many respects, this simply mirrors the situation of the new car market: Expensive SUVs are in demand. And more expensive new cars with more extras will ultimately fetch better prices on the second hand market as well. With new car costs rising quickly, there is plenty of space for used cars to appreciate. The only condition is that they shouldn’t get more expensive at a faster rater than new models.

What’s more, buyers of used cars tend to have a more limited budget than buyers of new cars. Keeping monthly instalments at a minimum is even more of a priority. To them, the willingness of lenders to offer 72- and 84-month loans for a second hand car is not predatory – but a godsend.

Summing it up I: Don’t trade time against quality

Cars are expensive. Popular models are even more expensive. Popular cars with a lot of extras are almost unaffordable.

And yet, more and more people are buying almost unaffordable cars. As we’ve seen, this has even led to car prices rising across the board.

Dealers will often actively support your desire for an unaffordable car. “You, too, can drive this car,” they will tell you, “Just extend the length of the loan. This will reduce the monthly rates to what you can afford. This way, you can pretty much buy any car you like.”

Your risk

As we’ve seen, however, extending your car loan term beyond normal levels has many drawbacks. The risk of the decision rests almost exclusively with you. The dealer can and will use your car as collateral. They’ll simply claim it back should you have to default on the loan. And this danger is very real:

As Bloomberg has reported, defaults on UK car loans are on the rise, driven by consumers who buy big but can’t afford it.

The lesson from this is clear: Buy safe. Don’t trade time and money against a supposedly better car. And make sure to read the next paragraph to get an idea about what this means in practise.

Summing it up II: When too long really is too long

There seems to be a general consensus among experts that 84- and 96- or 97-month terms are by far too long. An article on car site jalopnik, quoting the Wall Street Journal, stresses:

“You may end up paying a ridiculous amount in interest over those years. The WSJ piece even calls loans that are longer than 72 months “subprime loans,” which isn’t encouraging at all considering how those loans in the housing market hammered our economy.”

On the other end of the spectrum are those who claim that the very maximum you should agree to is 42 months – i.e. 3,5 years – the so-called Clark rule of car financing.

Obviously, such a short term loan will simply not be feasible for many cash-strapped buyers.

So the truth will have to be somewhere in the middle.

In an interesting assessment, the American Consumer Financial Protection Bureau has found that “six-year borrowers have a more than 8% default rate, while five-year borrowers have a default rate in the neighborhood of 4%.” This means that there seems to be a sort of a transition from a safe zone to a more precarious territory between 60 and 72 months.

Keeping this in mind, you should ideally restrict your loan to five years and try not to exceed six years. According to financial planner Ryan Fuchs, there is nothing wrong whatsoever with a 60 month car loan term, despite some experts protesting this might be too long:

“As long as you plan on keeping the car for a while (say at least 7 or 8 years), and the interest rate isn’t substantially higher, I would say not really. I would argue that it is reasonable to expect a useful life of at least 8-10 years on pretty much any new car these days (unless you treat it poorly and don’t take care of it and/or you put 30,000+ miles on it every year, or something like that), so paying it off over 5 years is not necessarily that bad of a thing.”

How to bring the term down

Okay, so you’ve decided to commit to restricting the length of the loan to 60 months. You are willing to keep your general expenses down to be able to pay a higher instalment. Still, you find yourself struggling to meet your targets.

To help you pull through with your goals, here are a few tips on how to bring the term of the loan down and get a better car deal.

Increase the downpayment

The higher the loan, the higher will be your monthly rates. One way of reducing the monthly payments, therefore, is to pay more upfront. Some kind of downpayment, even a small one, is always a good idea, as it also reduces the danger of ending up upside down on the loan.

The big question, of course, is whether you can afford to do this or not. Interestingly, many potential buyers are very much capable of saving up for a downpayment, even if their financial situation seems dire.

Just consider this: If you can afford a monthly payment of £150, why don’t you save this amount for a year before getting a car? Using this £1,800 and another £1,200 from your savings means you can achieve a more than decent reduction in the overall sum to be financed.

This, in turn, should allow you to bring down the length of the loan term considerably.

Improve your credit rating

We’ve touched upon this subject several times before on this blog. Obviously, improving your credit rating is not easy. If it were, you wouldn’t be spending a lot of time reading this article and finding out how to finance your car. On the other hand, there are many concrete steps you can take to at least make a start.

Moneyfacts.co.uk has provided a highly useful first guide to improving your credit rating, if you’re interested in finding out more.

Be modest

Cars are getting more expensive, this much is true. But it’s not just manufacturers who are causing the hike in prices. Customer demand, as we’ve indicated, tends increasingly towards pricier models and plenty of extras.

But the cheap cars have not gone away. Models like the Dacia Duster prove that you can still achieve a reasonable quality at a more than reasonable price. And if you spend enough time looking for second hand offers, there are plenty of incredible deals to be made.

Examine closely what you really need and what qualifies as wishful thinking. Be modest and, most of all, be realistic. Insisting on the car of your dreams when you can barely make ends meet is not a sensible starting point.

Buy smart

One important lesson to learn from buying and selling cars is that you can make a huge difference by picking the right brand and model at the right mileage/age.

Here are some concrete recommendations:

  • Many popular cars tend to depreciate slowly. This makes them less attractive on the second hand market. They may, however, be a good choice if you intend to drive them for a long time. If you pick the right moment, you may even be able to see them at next to no loss.
  • Almost all cars on the market today tend to be of a pretty high quality. If cost is your main concern and if you intend to drive your car for as long as possible, it can be a smart move to look for slightly less popular vehicles at around the 7-year mark. At this point, they will already have depreciated considerably. But they should still have many thousands of miles in them.
  • Buying a car even later in its lifecycle – say, after ten years – can be a good choice if you are handy and can keep the car in great shape. If you’re lucky you can drive such a car until it is paid off and then sell it at roughly the same price.
  • Research the quality of a particular model. The fascinating thing is how even models that are just one year apart can differ wildly in terms of reliability. This is rarely factored into the purchase price of a car, which usually just relies on mileage, age, extras and condition. By selecting a particularly reliable version of your favourite car, you can prevent expensive repairs and keep the total costs of ownership down.

Budgeting for car finance

Clearly, clever budgeting has an important role to play in all this. Just how much you can afford each month depends to a large degree on planning. Here are a few suggestions on how to improve your budget:

  • Set the budget before you start looking for a new car. This sounds like a no brainer. But it is not as common as you might think, unfortunately. The point of the exercise is to establish how much you can spend without falling prey to your irrational desires for a certain model.
  • Always work with the true, total costs of car ownership. This includes interest, depreciation, gas, maintenance and repairs.
  • It has been suggested to check if you can make payments every 14 days rather than every month. This may sound a bit strange. But the idea is actually quite clever: Paying twice a month allows you to squeeze in one more payment each year. This can result in a small, but notable improvement of the loan term.

New Rules

Rules can be a drag. But they can also be helpful. Which is why it makes sense to take a look at some of the recommendations about how much to spend on a car.

Setting a transportation budget prior to visiting a showroom is one of the best pieces of advice we can give you. As part of this, try to move away from absolute numbers. Instead, look at what you spend as a consequence of how much you earn. Or to put it differently: Tie your costs to your income. (For more tips, see our article on the best car room strategy)

How much, exactly?

Pete the Planner recommends that your monthly transportation costs should not exceed 15% of your total income. The Wall Street Journal makes this 20%, so this gives you a financial corridor. Both of these numbers are in accord with the well-known 50-30-20 rules of finance:

  • “50% for needs such as housing, food and transportation — which, in this case, is your monthly car payment and related auto expenses (more on that below).
  • 30% for wants, such as entertainment, travel and other nonessential items.
  • 20% for savings, paying off credit cards and meeting long-range financial goals.”

A car falls somewhere between needs and wants, depending on your use of it. The more it leans towards the needs category, the more you can reasonably pay for it. If you really require a car to get to work, for example, you can go as far as the upper limit of this corridor. Just don’t exceed it.

Car loan terms at CCC

At Concept Car Credit, we don’t regard car loan terms as rigid. Rather, we try to match them to your preferences and needs. We do believe that for many of our customers, the monthly rate is a valuable indicator of what they can afford. We also find that it usually pays off to buy a slightly better car with less risk of a repair. But we’re well aware that extremely long terms are a risk better to be avoided.

Most of all, we have found that it’s vital to take your time exploring this issue. For starters, you can use our online car loan calculator to run the numbers. Visit our online showroom to search for offers that meet your personal budget rules. And finally, do visit us at our physical store in Manchester to discuss all of these topics with us personally. We’re always more than happy to assist.

14 January 2019 Concept Car