Nationwide, about 5% of auto loan debt is in default, and the rate of new defaults is even higher. While that may sound like a small percentage, the raw numbers are big. About $66 billion in U.S. auto loan debt is 90+ days delinquent. Locally, the rates are even higher.
6% of Alabama automobile loans and 7% of Mississippi loans are delinquent, and those numbers are even higher in some areas. Both Montgomery County, Alabama and Hinds County, Mississippi have auto loan delinquency rates of 9%.
While any past-due debt can be stressful, delinquent automobile loans trigger special concerns. Unlike credit card debt and many other types of obligations, automobile loan default can mean repossession. Since many people are reliant on their cars to earn a living, repossession can make a bad financial situation worse, and turn a short-term cash crunch into a long-term problem.
Anyone can face unexpected hardships that make it difficult to keep payments up to date. But many people don’t realize that one simple decision when financing a vehicle can reduce the chances of default.
Longer-Term Car Loans are On the Rise
Once upon a time, 5-year car loans were the norm, and 3-year loans were also popular. But loan duration has been on the rise for several years. In 2015, the average length of an automobile loan had climbed to more than 67 months. In March of 2020, the average surpassed 70 months–just shy of six years–for the first time.
Few people are excited about the prospect of making loan payments for six or seven or even eight years…so why are so many people opting for longer loan terms? The main motivation for taking out a longer-term loan is that it lowers monthly payments. Lower monthly payments can help someone who might otherwise have trouble getting approved for a loan finance a vehicle and get on the road. Stretching out payments can also help people qualify for more expensive vehicles.
That obviously carries appeal for a lot of people. In 2019, Experian reported that 33.8% of new car loans and 62% of used car loans originated during the first quarter were 73-96 month financing. For most, though, these loans turn out to be a bad deal.
Pitfalls of Long-Term Car Loans
Longer-term car loans put consumers at risk in many ways, including:
- Long-term loans tend to be offered at higher interest rates
- Even at similar interest rates, a long-term loan is much more expensive than a shorter-term loan
- Longer-term borrowers tend to finance larger amounts
- Longer-term loans generally keep vehicle owners “underwater” for most of the loan, making it hard to sell or trade in the vehicle
- Longer-term loans create a greater likelihood of serious issues with the vehicle before the loan is paid off
- Longer-term loans are more likely to end in default
Of course, many variables work together to determine the success or failure of an automobile loan. We know that automobile loan default rates for loans longer than six years (72 months) are nearly double the rate for five year (60 month) loans. But that doesn’t mean the longer loan term is the sole cause of the default. Many longer-term borrowers have lower credit scores when they take out the loan, meaning they may already have been facing challenges that made default more likely.
Still, the duration of the payments, higher long-term costs, and greater likelihood of taking out a larger loan combine to increase the risk. The downsides become obvious in a side-by-side comparison.
In June of 2020, two buyers finance $23,000–the average price of a 2019 Honda Accord less a $1,000 down payment. One finances the car for 36 months and the other for 72. Each pays the average interest rate based on the loan term: 4.21% for the 36-month loan and 4.45% for the 72-month loan. Of course, monthly payments are lower for the 72-month borrower, at $364.57 versus $681.20.
It’s easy to see how longer-term loans happen, since many people in need of a vehicle aren’t in a position to pay nearly $700/month. But that doesn’t mean a six-year car loan is the answer.
Across the loan term, the 36-month borrower pays $1,523 in interest, while the longer-term borrower pays $3,249. In those three years, the vehicle will typically lose about 33% of its value. That means after 36 months, the car is worth about $16,000. The three-year borrower has paid off the car and has a vehicle worth $16,000 to continue to drive without payments, trade in, or sell.
The six-year borrower, on the other hand, still owes $12,265. He’s still fortunate compared with someone who purchased a more expensive car or who stretched out the loan term to seven or eight years–he has a small amount of equity in the car.
Ultimately, the longer loan:
- Costs more than twice as much in interest
- Leaves the buyer with significantly less equity in the vehicle, reducing options
- Allows twice as much time for an income disruption or emergency to put the loan in default
- Allows twice as much time for problems to arise with the vehicle
- Results in a much lower value asset by the time the loan is paid off
Lower payments may be appealing, and financing over a long period of time may seem like the only way to secure the vehicle you need. But, think strategically about your car loan and consider more than the monthly payment. While you don’t want to stretch yourself too thin, don’t automatically go for the lowest payment. In the example above, reducing the loan term from six years to five would add just $64/month to the payment, but would result in payoff a full year earlier, achieving equity in the vehicle sooner, a reduced risk of default, and a $553 reduction in interest.
If you can’t afford even a small increase in the monthly payment, consider lowering your sights and purchasing a more affordable vehicle that will allow for shorter-term financing.
Thinking strategically about your car loan is a good way to reduce the risk of default and repossession. But, if your loan is already delinquent, it’s time to consider different strategies. If you’d like to learn more about how bankruptcy may stop motor vehicle repossession, schedule a free consultation with one of our experienced bankruptcy attorneys. Just call 877-581-3396 or fill out the contact form on this page to get started.
Don Lawson is the Office Manager of the Bond & Botes Law Offices location in Knoxville, Tennessee. He holds degrees in both Accounting and Finance that he’s put to use analyzing complex business bankruptcy cases for the firm. Read his full bio here.