Financing deals can keep monthly payments low, but you may end up paying more in the long run

Amid slow sales, there are a lot of great deals to be found on new and used vehicles. On the new car side, 0 percent financing on long-term auto loans has quickly become the norm. But before you go out and sign on to a seven-year commitment on a new car, even at 0 percent, Consumer Reports’ experts advise doing some numbers crunching.

That’s because some cars depreciate at a faster pace than a loan can be paid down, especially over so many years. That means there could be a period when you owe more than your vehicle is worth, also known as being underwater or upside-down. In the case of an accident that totals the car, that could mean a financial disaster.

Chuck Bell, programs director for advocacy at Consumer Reports, recommends that consumers take a conservative approach to how much they spend on a vehicle.

“In the past the rule of thumb for car financing was the 20-4-10 rule: Make a 20 percent down payment, take a 48-month loan, and spend no more than 10 percent of your budget on all vehicle expenses, including maintenance and insurance,” he says. “Now many households are spending an average of 11 percent just on car payments alone.”

Being upside-down on an auto loan is fairly common. According to new research from Edmunds, 44 percent of new car sales involve a trade-in with negative equity. While negative equity isn’t necessarily much of a problem while you own the car, it can put you at risk financially if you decide to trade it in or if it is damaged. If a vehicle is declared a total loss in an accident, you will still be liable for the loan balance that insurance doesn’t cover. And if you want to sell your vehicle and buy something else, a vehicle often depreciates faster than you can pay down a loan over six or seven years.

So why do people take out loans that last longer than many people keep cars? The simple answer is to make it possible to stretch and buy more car.

“Consumers have increasingly been gravitating toward more expensive vehicles, such as trucks and SUVs, so long-term loans may offer a way to offset monthly costs,” says Carolyn Gasbarra, a spokesperson for TransUnion, a credit reporting agency. She also says a general increase in vehicle prices has made affordability a problem for many car shoppers.

“Consumers may also be more receptive to a long-term loan as vehicles are lasting longer on the road,” she says.

According to ALG, TrueCar’s analytics arm, cars are, in fact, lasting longer than ever before—an average of 12 years. Total-loss accidents notwithstanding, keeping a vehicle paid for with a long-term auto loan for many years could, technically, work out for the consumer. But it’s seldom that simple.

“We know there are layers to vehicle ownership, from people who flip leases on new vehicles to people struggling to afford the payment of a subprime ‘buy here, pay here’ loan on an eight- to 10-year-old vehicle,” says Alain Nana-Sinkam, ALG’s vice president of strategic initiatives. Based on ALG’s research, most new vehicles that are sold—as opposed to leased—end up being sold again as used cars four or five years later.

Bell says stagnant household incomes and rising vehicle prices have led to a situation where automobile ownership is taking a bigger bite out of people’s monthly budget. And as T8Auto has said before, the cost of car ownership usually exceeds monthly payments on a loan.

“Stretching out the payments doesn’t make the car itself more affordable if you take the longer view,” he says. “It’s sort of like the frog in the pot of lukewarm water that is gradually heating up. You don’t notice the change year over year, but if you step back and look at what is happening to consumer household budgets, you see many people really straining to keep up with the rising costs of vehicle ownership.”

Payment deferrals, while appealing to customers facing employment instability amid economic turmoil, amount to kicking the financial can down the road. Deferral programs delay the onset of financial responsibility by several months as the vehicle continues to depreciate. Nana-Sinkam says that even though a payment deferral delays paying off a loan and can increase the total amount paid, three months isn’t likely to make an alarming difference.

Nana-Sinkam says that a disciplined consumer could use a long-term 0 percent auto loan as a way to free up financial resources for investment. Under normal circumstances—with a higher-interest or shorter-term loan—the monthly payment would be higher than it would be with no-interest financing. Basing his calculations on an average vehicle price of $38,000, he came up with a rough outline of the potential benefit. 

“A savvy and engaged consumer would take the 0 percent, 84-month loan and siphon the $223 monthly savings into an investment,” he says. “Over five years, with an estimated 4 percent return, that pool of funds would yield close to $15,000, which is nearly $3,000 more than the positive equity position you’d find yourself in at the end of a 60-month loan with a 3 percent interest rate.”

Nana-Sinkam says the 0 percent, 84-month loans that are so prolific right now will mainly appeal to two very different types of buyer: the “buy and hold” shopper who plans to drive the car until the wheels fall off, and the “three digit” shopper whose financial situation puts them at the mercy of the monthly payment amount.

“There is some meaningful part of the American consumer body that consistently has to pass on financial strategies they know are ‘smarter’ in order to make ends meet,” he says. “Over 60 percent of the American public does not have enough money in the bank for a $500 emergency. That’s uncomfortable, but it’s true.”

Bell says consumers should give themselves budgetary breathing room to free up money for longer-term investments.

“I think consumers are better off when they take a hard look at the rising cost of new cars, and are more conservative in the percentage of income they want to devote to car payments and the total cost of car ownership,” he says. “Superlong loans are not a great idea, even if it seems a lot of people are doing it. Unless you can come up with a really large down payment, you will owe more than the car is worth for many years to come.”