It has been reported that 7 and 8 year car loans are becoming the norm. This isn’t surprising, when you consider that the cost for a new mid-size family car, mini-van, hybrid, or small SUV can easily be $25,000, and it is not uncommon that if nice features are added they can easily cost $30,000 – $35,000. Full size models with a lot of features, or more luxury brands can kick the cost to above $40,000.
Many people look at the monthly payment, and they buy based on what they think they can afford. However, I find that most people don’t do a budget (nor live by one) before making a final decision based on monthly payment amount.
Before purchasing, it is not uncommon for new car purchasers to:
- Fail to calculate what their real budget is: They often think they can afford something but in reality there isn’t enough room in their budget for the new car payment.
- Fail to calculate the overall cost of buying a car: The cost includes final purchase price, which includes title and other dealer fees they add on. Secondly, most states have a sales tax. Assuming someone purchases a $27,000 car, pays 6% sales tax, and $500 in other fees: The purchase price is $29,120. This doesn’t include rebates or dealer discounts.
- Fail to know how much total interest they will pay: Using this example, lets assume they put $2,000 down, they will borrow $27,000 at an assumed interest rate of 5% (this will be depend upon credit rating and arrangements the car dealer has with lenders), and financed it for 7 years. The total interest paid on the loan would be $5,055.
- Fail to know how much they will be upside down when they drive their car off of the lot: That new car will depreciate about 10%. That new car purchased for $27,000 will now only be worth about $24,300, even though they owe the bank $27,000.
- Forever upside down: Especially with a long-term car loan, because of the interest you owe and the car’s depreciation, and small down-payment, you most likely will own more than the car is worth for the entire term of the car. If you run into financial problems, like become unemployed, or underemployed, and run out of savings, you might not be able to sell it if you owe more that it is worth. So now you have a car you can’t afford or able to sell! Hello repo-man.
- Fail to calculate the impact to their financial net worth: On their balance sheet, on the asset side they can add the car’s value of $24,000, however on the debt side, they have a $27,000 debt plus $5,055 in interest, for a total liability of over $32,000. So their net worth decreased by $8,000 ($32,000 – $24,000).
- Fail to consider fuel and maintenance cost: Some people are really savvy buying high MPG and hybrid vehicles, however many people don’t compare that at all to other models, nor do they compare it to their current car and buy a car that is more thirsty on gas.
- Debt is betting on the future. It assumes that you can afford the payment for a long-term, even though your employment, health, and overall financial situation and economy could worsen. It is spending tomorrow’s income, before you even have it. It is taking many things for granted.
For those really economically minded, they buy used cars with cash or short-term loans. They also calculate the total cost of ownership: purchase price and cost, interest, fuel, insurance and maintenance. Short-term loans have higher payment, making them not as affordable for many car buying consumers. This tempts many people to lease instead of buying. Most financial experts though like Dave Ramsey recommend not leasing or as Dave calls them car-fleeces. Some very well healed people lease cars, and get a new one every few years, but for those on a tight budget, working hard to minimize debt and build wealth, if you have to borrow, short-term loans are the way to go (with large down-payment). Patiently buying good used cars with cash, and maintaining them well is usually the best way to go financially.
