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Why you shouldn't finance a car for seven years

You're likely to find yourself owing more than the car is worth at trade-in time

Photo (c) photobuay - Fotolia
Coming out of the Great Recession, the auto industry was one of the first areas of the economy to get back on its feet.

While mortgage lenders became a lot more difficult to deal with, there was plenty of credit for car buyers, often with generous terms. Interest rates were rock bottom, and if you had a job, it wasn't hard to qualify for a loan.

As a result, car sales posted records year after year and consumers purchased and leased increasingly expensive vehicles. The average transaction price (ATP) on a new vehicle now fluctuates between $33,000 and $34,000.

To afford the monthly payments on a loan of that size, lenders have increased the lengths of the loans. Five year loans soon because six year loans. Now, a report by Automotive News, based on data from Experian, finds that loan terms of 73 to 84 months -- seven years -- made up nearly a third of new car loans in the fourth quarter of last year.

Industry concern

The automotive industry publication cites that as a concern for the industry, as well as consumers, because consumers are trading in vehicles still owing a lot of money. The average negative equity on a trade in during the first quarter was $5,195, according to Edmunds.com.

At the same time, the record sales of new cars has produced a glut of used cars -- a glut that is making used cars worth less, accelerating the increase in negative equity. It puts consumers who purchased expensive automobiles and financed them for six or seven years in a precarious position.

While a house can be expected to gain value over time, an automobile loses value the minute you drive it off the lot. If you aren't paying down the loan fast enough, you soon find yourself underwater, just like those homeowners who purchased houses with subprime loans more than a decade ago.

Carmakers and dealers have encouraged consumers to purchase more expensive vehicles by extending the time to pay for them.

More bells and whistles

"Buyers want pricier cars with more bells and whistles, leading to the troubling trend of trading longer loan terms for lower monthly payments," said Edmunds' analyst Jessica Caldwell. "But now that interest rates are also on the rise, something has to give."

The takeaway for consumers is to only purchase a vehicle that can be paid for while you're still driving it. If you plan to trade in the car in five years, only finance it for five years. That way, you still have some residual value that can be used for a down payment.

An even better plan is to finance the vehicle for a year less than you plan to drive it. That way you get a year of ownership without a car payment.

Of course, to do that you may need to look at vehicles you can purchase for $18,000 instead of $34,000 -- vehicles without so many bells and whistles.

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