The average new car loan in the second quarter of this year was $36,072, according to Experian Automotive, nearly $4,000 more than the typical loan a year earlier.
That would be a startling jump in a booming economy where jobs are secure, but in the midst of a recession expected to have long-lasting effects on job security, it’s remarkable.
And it represents a major risk to many households. What’s likely driving the auto borrowing binge is that interest rates are so low; the monthly cost to finance that extra $4,000 only adds about $18 to a monthly payment. And low gas prices are adding to the faulty judgment, as it encourages some buyers to go for the bigger (less fuel efficient) car.
Given that a car is a lousy investment — it is guaranteed to lose value, and new cars typically depreciate up to 40% or so in the first few years — the goal should be to borrow as little as possible.
Experian Automotive says the average car loan now runs for about 71 months. Four in 10 new car loans in the second quarter were for more than 73 months. Let’s keep it simple and assume the typical new car loan is for six years (72 months). If your finances are such that you had to borrow to buy a car, that’s a long time to assume you can afford such a big payment, given today’s rocky economy.
Let’s say that instead of taking out a $36,000 loan for six years, costing you around $570 a month, you instead borrowed $21,000 for a used car, which happens to be the norm, according to Experian Automotive. Let’s assume you have a pretty strong credit score and can qualify for a 5% loan rate on the used car, which you will pay back in four years. That works out to a monthly payment of around $485.
A monthly payment at $80 less is great, but the bigger gain is that you will be done paying back the loan two years earlier. That’s 24 months with no car payment.
What to do with the $485 a month for two years? Well, that’s $11,640 more for the emergency fund you keep worrying isn’t big enough. Already have a plump emergency stash? How about retirement?
Invest $485 a month for the two-year stretch and leave that money to compound for, say, 25 more years, and it will be worth around $40,000, assuming a conservative long-term annualized return of 5%. Got 35 years until retirement? It’ll compound to $66,000. All because of a car buying choice you make today.
Buying the used car with a smaller loan is the biggest of no-brainers for recent college grads gnashing their teeth about their student loan debt. For the record, that student loan is likely the best investment you will ever make, given the long-term income boost premium over your entire career: https://www.rate.com/research/news/good-news-student-debt
Put 24 months of $485 payments toward your student loans and you will seriously speed up getting it paid off. Among students who graduate with debt, the average borrowed amount is around $30,000. The $11,500 you freed up by not having a car payment will bring the balance way down.
Car production was halted for a time due to the coronavirus, meaning certain new models are scarce. That makes it harder to bargain. But the big market for leasing a car in the past few years has generated a pool of lightly used cars for resale. Those returned leased cars waiting to be sold off are a sweet spot for smart car buyers. You’re letting someone else pay for the depreciation, and you can get a reliable car at a price easy to finance in a three- to four-year loan.