When Car Debt Turns Really, Really Bad

Here's some bad news on car debt from financial writer Michelle Singletary:

This year consumers have hit another landmark. The majority of auto loans are now written for five years or longer.

New-vehicle loans over 60 months accounted for nearly 55 percent of loan originations, according to the Consumer Bankers Association's 2006 Automobile Finance Study. Used-vehicle loans over 60 months accounted for 40 percent of originations.

In 2000, five-year or longer car loans made up just 22 percent of all such lending.

This news is followed by the understatement of the day:

"It is to a certain degree a sign that people are stretching," said Fritz Elmendorf, vice president of communications for the Consumer Bankers Association. "It does raise the question of whether people are buying more car than they can afford and should they put the brakes on their car-buying behavior."

Ya think? I guess it doesn't take much firepower upstairs to be vice president of communications for the Consumer Bankers Association, huh?

Ok, that wasn't fair, but let's use some stronger language and tell it like it is: people continue to spend more than they make, making up the difference by borrowing. They're doing it with interest-only and 50-year mortgages with houses, so why not with cars?

Unfortunately, this leads to a big hit on net worth for these people as many end up owning an "asset" that has more debt on it than the asset's value:

This trend is troubling because stretched-out auto loans have led to another milestone, an increase in the percentage of vehicle owners who are "upside-down." That's a term used to mean your loan balance is higher than the value of the asset that secures the loan, in this case your car. With a longer-term loan, the car's value declines faster than the loan balance.

This can be more than a net worth hit -- it can be a dangerous financial position in several different scenarios. A couple of them:

That certainly is not a good position to be in if you want to trade or privately sell your vehicle. Oh, and you had better pray you don't get into an auto accident and the car is totaled. If it is, you won't get enough of an insurance payment to pay off the loan.

In addition, borrowing for a longer period of time is much more expensive. You usually have to pay higher interest rates for longer loans and, of course, you're paying the loan for a longer period of time so you pay more interest. Here are two examples:

Let's say you finance a car for $23,500 for 60 months at 7 percent. Your monthly payment is $465.33. At the end of that loan you would have paid about $4,420 in interest. Finance that same vehicle for 48 months at 5.5 percent and you will pay about $2,730 in interest. Your monthly payment is higher, $546.53, but you save $1,690 in interest over the life of the loan.

Yep, you read that right -- one extra year of payments and almost $1,700 more in interest.

Here's what I do: pay cash. Years ago, we kept our expenses under control while our income increased. We paid off our cars, then our house, then started saving for our next cars. When we had enough to pay cash and the current cars weren't worth much any more, we bought new ones (getting great deals because we had CASH -- paying in cash can be a great way to negotiate a lower price). Then we started the process over again.

For those of you interested in saving on car purchases and expenses, check out Thoughts on Cars: How to Buy One and What They Cost.

Comments

[Daniel]

I'm guilty. I posted about being upside down last week. I only did a 60 month loan, but I drive so many miles, I've gone upside down on my loan. I'm at 3.9% interest, so I don't feel the need to pay off early. I've recently moved closer to work so hopefully that will get me right side up quicker. Here is a link to my post: http://mymoneypath.blogspot.com/2006/07/im-upside-down-on-my-car-loan.html

[GHoosdum]

I don't understand how you can get a *better* deal by paying in cash - half of the dealership's profit comes from the financing that they sell you. If you pay in cash or finance from a credit union (as my wife did) the dealership makes LESS, so they will try their best to make the purchase price HIGHER on a new car sale.

I've often heard that the best way to pay in cash for a car is to negotiate the price while letting the dealership assume they'll be able to sell you financing, then dropping the "I'm paying cash" bomb on them at the end, once the price is negotiated. They might try to renegotiate at that point, to increase the price to a level that they'll profit... but I really can't understand how or why a dealership would LOWER the price for a cash buyer.

[Dale]

There are now special insurance policies that will pay the difference between what your car insurance covers and the outstanding balance on the loan if you total your car while you are upside-down on the loan. I first heard of them two years ago, which was a clear indication that loans structured such that they were upside-down for a period of time had already become fairly common then.