The average new-car loan in the second quarter of this year was $36,072, according to Experian Automotive, nearly $4,000 more than the typical loan a year earlier.
That would be a startling jump in a booming economy where jobs are secure, but in the midst of a recession expected to have long-lasting effects on job security, it’s remarkable.
And it represents a major risk to many households. Given that a car is guaranteed to lose value, the goal should be to borrow as little as possible.
Experian Automotive said the average car loan now runs for about 71 months. Four in 10 new-car loans in the second quarter were for more than 73 months. Let’s keep it simple and assume the typical new-car loan is for six years (72 months). If your finances are such that you had to borrow to buy a car, that’s a long time to assume you can afford such a big payment, given today’s rocky economy.
Let’s say that instead of taking out a $36,000 loan for six years, costing you around $570 a month, you instead borrowed $21,000 for a used car, which happens to be the norm, according to Experian Automotive. Let’s assume you have a pretty strong credit score and can qualify for a 5% loan rate on the used car, which you will pay back in four years. That works out to a monthly payment of around $485.
A monthly payment at $80 less is great, but the bigger gain is that you will be done paying back the loan two years earlier. That’s 24 months with no car payment.
What to do with the $485 a month for two years? Well, that’s $11,640 more for the emergency fund you worry isn’t big enough. Already have a plump emergency stash? How about retirement?
Invest $485 a month for the two-year stretch and leave that money to compound for, say, 25 more years, and it will be worth around $40,000, assuming a conservative long-term annualized return of 5%. Got 35 years until retirement? It will compound to $66,000. All because of a car-buying choice you make today.
Buying the used car with a smaller loan is the biggest of no-brainers for recent college graduates gnashing their teeth about their student loan debt.
Car production was halted for a time because of the coronavirus, meaning certain new models are scarce. That makes it harder to bargain. But the big market for leasing a car in the past few years has generated a pool of lightly used cars for resale. Those returned leased cars waiting to be sold off are a sweet spot for smart car buyers. You are letting someone else pay for the depreciation, and you can get a reliable car at a price easy to finance in a three- to four-year loan.
Carla Fried writes for Rate.com, a personal finance and residential real estate news website.