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# What is the Maximum Length of Time You Should be Paying For a Car?

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**Written by Cassandra Garnett**

June 10, 2018 |

If you think you can continue making payments on a car for 84 months, you are ignoring critical details that will bite you down the road.

Car dealers today seem to be doing everything in their power to keep you from knowing the actual price of a car. By advertising 0% interest over extremely long loan terms - like 84 months (which is 7 years!) - the payment you are asked to make seems easy to absorb. That payment, incidentally, is almost always expressed as*bi-weekly*, because if it was stated in monthly terms, it might scare off today's debt-riddled consumer. These payment terms mask the key consideration in determining how long is appropriate in term length for a car loan. That consideration is the length of time you, as the car owner, spend stuck with *negative equity*.

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Negative Equity

The moment you take ownership of a car and drive it off the lot, you've just lost 10% of its value, and you will lose another 10% before you've owned the car for a year. That is the effect of depreciation, and it aligns with common sense: who wants a car someone else has driven, and probably driven poorly? Sure, its not as though you're buying a used Q-Tip, but consumers prefer the comfort of knowing no one else has used and abused their car.

But that comfort comes with a huge price. Your car depreciates severely in the first year, and then continues to gradually depreciate over time. Even with a 0% interest rate, you will owe more on your car than it is worth for 5 years.

Assuming you experience the average rate of depreciation of 20% per year over the first 4 years of ownership, and then 10% for the remaining 3 years of the term of your loan, your equity situation will look like this on a car that originally cost $25,000.00:

For 5 years you will be paying a large amount of money, chasing a falling value that you cannot catch. 5 years is more than half the term of the entire loan, which means that 84 months is not only a bad idea for you, its a bad idea for anyone. You should never spend more than half your loan payback term in negative equity, and ideally you should not have negative equity for more than 1 year.

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Repairs in later years

Eventually, all cars need repairs. Some are unexpected, like a broken water pump or alternator. Still others are routine, like new tires and brakes. These wear and tear items are not specific to any brand or even any vintage: new cars sometimes have tires that wear out quickly and sometimes they seem to last forever.

But exposed to the elements, as well as the physical forces of accelerating and stopping, eventually your car will need to have something fixed. When you buy a used car, the expectation of repairs comes with the territory. But with a new car, it can be tempting to think that repairs are either not necessary, or something so far down the road that they will be the problem of the next owner.

With a commitment of 84 months, you can be sure that car repair bills will be paid with money out of your wallet. Frugal though you may be, 84 months is just too long a duration to go without replacing the car's tires and brakes. You can push it if you want, but considering the safety risks you would be taking, it would not be worth it.

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Cars in your budget

If you think about the percentage of your take home pay you should limit to transportation costs, a good rule of thumb is about 6%. If you earn the same amount as the average hourly worker in the United States, then 6% of your take home pay equals approximately $2,455.70 per year. The harsh reality of that number is it includes not only ownership costs, but also maintenance and fuel costs as well. Obviously, if you are paying 0% on a $25,000.00 car over 84 months, and that total is $3,571.43 in ownership costs alone, you cannot afford that car without negatively affecting other areas of your budget, such as saving for retirement.

Considering that buying a car with an 7 year pay back term implies that for 3 of those years you will*by definition* be driving a 4 year old used car, why not just start with that situation right now? If you believe you cannot afford the payment and maintenance costs of a 4 year old car today, what makes you think you will be able to pay them 4 years from now? And the kicker is that if you buy a $25,000.00 car with a 7 year pay back, you will be paying that same monthly amount in years 4 through 7 as you did in years 0 through 4. Will you be as satisfied with paying the same amount of money each month for a 4 year old car as you did for a brand new car?

Taking the example of the $25,000.00 car purchased after year 4 (with a depreciated value of $10,240.00) and assuming you actually have to pay interest on a loan from the bank at 6% per year, you can pay off the exact same car in 5 years with an annual cost of $2,376.00. Further, for all but the first year of ownership of the used car, you will have positive equity. That means that if you ever decide to sell and pay off the loan, the amount you get from selling the car will entirely pay off the outstanding loan balance.

Due to the nature of negative equity on a new car, you would actually be better off selling a 4 year old used car after owning it for 3 years than you would selling a brand new car after owning it for 3 years. Selling a new car after 3 years will mean you will need to repay a remaining loan balance of $1,485.71. Selling a used car after 3 years will mean not only is the entire loan paid off, but you will pocket a gain of $2,003.75 that you can use toward the purchase of your next 4 year old used car.

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Summary

The maximum length of time you should ever commit to a pay back term should be measured by how much of that term you spend in*negative equity*. Paying loan amounts against an asset that is worth less than the loan you are paying is demoralizing, as well as risky. If you ever need to sell the car to free up cash, it is discouraging to know that even after the sale of the car you will still owe money on the loan.

The solution? Consider a used car, particularly a car that is approximately 4 years old. Very quickly during your ownership of the used car, you will stop having negative equity and start building positive equity. Selling the car before the expiry of the loan term on a user car will result in extra cash you can use to help purchase your next used car.

Are you caught in a car loan that has you facing negative equity? What advice do you have for prospective car owners considering a long term on a car loan?

Car dealers today seem to be doing everything in their power to keep you from knowing the actual price of a car. By advertising 0% interest over extremely long loan terms - like 84 months (which is 7 years!) - the payment you are asked to make seems easy to absorb. That payment, incidentally, is almost always expressed as

The moment you take ownership of a car and drive it off the lot, you've just lost 10% of its value, and you will lose another 10% before you've owned the car for a year. That is the effect of depreciation, and it aligns with common sense: who wants a car someone else has driven, and probably driven poorly? Sure, its not as though you're buying a used Q-Tip, but consumers prefer the comfort of knowing no one else has used and abused their car.

But that comfort comes with a huge price. Your car depreciates severely in the first year, and then continues to gradually depreciate over time. Even with a 0% interest rate, you will owe more on your car than it is worth for 5 years.

Assuming you experience the average rate of depreciation of 20% per year over the first 4 years of ownership, and then 10% for the remaining 3 years of the term of your loan, your equity situation will look like this on a car that originally cost $25,000.00:

Year | Accrued Payment | Depreciation % | Depreciation Amount | Car Value | Equity |
---|---|---|---|---|---|

1 | $3,571.43 | 20.00% | $5,000.00 | $20,000.00 | -$1,428.57 |

2 | $7,142.86 | 20.00% | $4,000.00 | $16,000.00 | -$1,857.14 |

3 | $10,714.29 | 20.00% | $3,200.00 | $12,800.00 | -$1,485.71 |

4 | $14,285.71 | 20.00% | $2,560.00 | $10,240.00 | -$474.29 |

5 | $17,857.14 | 20.00% | $2,048.00 | $8,192.00 | $1,049.14 |

6 | $21,428.57 | 10.00% | $819.20 | $7,372.80 | $3,801.37 |

7 | $25,000.00 | 10.00% | $737.28 | $6,635.52 | $6,635.52 |

For 5 years you will be paying a large amount of money, chasing a falling value that you cannot catch. 5 years is more than half the term of the entire loan, which means that 84 months is not only a bad idea for you, its a bad idea for anyone. You should never spend more than half your loan payback term in negative equity, and ideally you should not have negative equity for more than 1 year.

But exposed to the elements, as well as the physical forces of accelerating and stopping, eventually your car will need to have something fixed. When you buy a used car, the expectation of repairs comes with the territory. But with a new car, it can be tempting to think that repairs are either not necessary, or something so far down the road that they will be the problem of the next owner.

With a commitment of 84 months, you can be sure that car repair bills will be paid with money out of your wallet. Frugal though you may be, 84 months is just too long a duration to go without replacing the car's tires and brakes. You can push it if you want, but considering the safety risks you would be taking, it would not be worth it.

Considering that buying a car with an 7 year pay back term implies that for 3 of those years you will

Taking the example of the $25,000.00 car purchased after year 4 (with a depreciated value of $10,240.00) and assuming you actually have to pay interest on a loan from the bank at 6% per year, you can pay off the exact same car in 5 years with an annual cost of $2,376.00. Further, for all but the first year of ownership of the used car, you will have positive equity. That means that if you ever decide to sell and pay off the loan, the amount you get from selling the car will entirely pay off the outstanding loan balance.

Due to the nature of negative equity on a new car, you would actually be better off selling a 4 year old used car after owning it for 3 years than you would selling a brand new car after owning it for 3 years. Selling a new car after 3 years will mean you will need to repay a remaining loan balance of $1,485.71. Selling a used car after 3 years will mean not only is the entire loan paid off, but you will pocket a gain of $2,003.75 that you can use toward the purchase of your next 4 year old used car.

The maximum length of time you should ever commit to a pay back term should be measured by how much of that term you spend in

The solution? Consider a used car, particularly a car that is approximately 4 years old. Very quickly during your ownership of the used car, you will stop having negative equity and start building positive equity. Selling the car before the expiry of the loan term on a user car will result in extra cash you can use to help purchase your next used car.

Are you caught in a car loan that has you facing negative equity? What advice do you have for prospective car owners considering a long term on a car loan?

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