Photographer: Daniel Acker/Bloomberg

Here's a Smart Trade-Off for New Car Buyers

Those great-sounding loan terms aren't nearly so great for consumers in the long run

The latest numbers on new car buying show that a flurry of purchases in May lifted the annualized sales rate to 17.8 million. That's well ahead of the 16.7 million pace from a year ago, and it's the highest level in 10 years. No surprise, most consumers are borrowing to make the purchase.

Experian Automotive reports that 85 percent of new car sales involve financing. Total car loan debt tipped the scales at $905 billion in 2015's first quarter, up more than $90 billion from a year earlier. While consumers are being pitched more financing options than ever, the smartest long-term strategy may be to ignore the most enticing offers.

A generation ago, the average length of a new car loan was 36 months. Today, 4 percent of new car loans are that short, according to Edmunds.com. The average loan now runs to more than 67 months, and the percentage of new car loans exceeding six years has revved up from 7 percent in 2008 to 24 percent.

While thinking long-term is a smart approach to retirement planning, a long-term strategy for car financing is another thing. The longer the loan, the more you pay in interest charges over the life of the loan. The average new loan term recently was 4.7 percent. And most people will be paying interest. Edmunds.com reports that just one in 10 people financing a car have the credit bona fides to qualify for the juicy zero-rate deals plastered on advertisements.

Moreover, the longer the term, the higher the rate. For example, SunTrust Bank advertises a new car loan rate of from 3.3 percent to 4.29 percent for loans running from 37 months to 48 months. Stretch out payments from 61 months to 72 months and the rate ranges from 4.7 percent to 5.7 percent. Even though those rates are historically low—the average was above 7 percent before the financial crisis—the interest on long-term loans still adds up quickly.

Experian Automotive reports that the average amount that car buyers are financing for new cars is $28,700. Pay that back in four years at a 4 percent rate and you’ll pay around $2,400 in interest. Stretch the payments to a 72-month loan at, say, 5.5 percent, and interest clocks in at more than $5,000.

There may be a sane argument for doubling interest payments for an asset with the potential to appreciate over time. It might be worth it for an asset such as a house, on which you get a nice tax break. But Edmunds reports that cars depreciate 22 percent the first year, and it’s downhill every year.

Moreover, the longer the term, the longer you run the risk of being upside down, or owing more on the loan than the car's market value. If you want to trade in your old car for a new one, your cost is the price of the new car plus what you must pay the lender. In March, almost 30 percent of car buyers trading in a vehicle for a new car were upside down on a car loan—up from 23 percent in 2011, according to Power Information Network. 

The smarter move: Resist car-financing come-ons that are predicated on consumers not thinking about long-term trade-offs. Instead, ratchet down your car-buying budget so you can handle the payments on a shorter loan. That may mean not getting a dream car, but it may help get you closer to a longer-term dream—affording retirement.

How so? Well, with the average monthly car payment about $480, if you get rid of that payment in four years (rather than six or more) in year five you can put that monthly $480 toward fully funding an IRA, if you're younger than 50. It's not the sexiest choice. But it's a trade-off most people will appreciate over time. 

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