Avoiding the Disaster of a Bad Car Loan

Consider carefully before you agree to a long loan

Are you underwater in your car loan? If you’re in the middle of a five-year, six-year or longer-term loan, you could be in a bad car loan. The terms “underwater” and “upside down” refer to the instance when you owe more money on your vehicle loan than what the vehicle is worth. It has gained a lot of currency in the home-mortgage arena as housing prices have tumbled, but it is also an issue with car loans. Most consumers find themselves underwater for a simple reason: the pursuit of the lowest monthly payment possible. There was a time when the standard auto loan was just 24 months. But as cars grew more expensive, loan terms stretched to three years, and then to four years. Now, industry data indicates that the average car loan term is more than 60 months.

Many owners have little or no equity in their car

Because the long-term loans are often accompanied by relatively small down payments, a vast majority of buyers have less equity (real ownership) in their cars than they might believe. Though you’ve religiously made three years of payments on your five-year loan, the financial institution might own more of the car than you do. Plus, the vehicle’s value is less than what you owe the financial institution to complete the loan.

Consumers with a 60-month loan will frequently walk into a dealership after three or four years with the goal of buying a new car, and that is where being underwater can hit home with a vengeance. Before they can even consider buying a new car, the first hurdle is to get clear of that old debt, which can run into the thousands of dollars. This is where some prospective buyers decide that getting a new car isn’t the right move, but that isn’t something the typical dealer wants to hear. So, dealers typically say they will “work with you” to solve the debt problem. Their usual solution, however, isn’t all that financially palatable. It consists of rolling the accumulated debt from the old vehicle into the loan on the new vehicle.

Long loans limit your financial options

Here’s an example. A Texas dealer signed a customer to a $47,000 96-month (8-year) loan on a big SUV, a loan that was for some $15,000 more than the value of the vehicle the customer was buying. The customer got his new vehicle, but he guaranteed himself that he would be underwater — and making huge monthly payments — for many years to come.

While it might seem fine to accept more debt to buy a new car, the result of all this is that individual consumers keep falling deeper and deeper into debt. Some have now found that filing for bankruptcy is a better solution than continuing to live with the huge debts they’ve accumulated. Over the past several years, we have seen a number of financial institutions get burned from this merry-go-round of escalating debt. Seven years ago, we predicted that this would be a problem. Now, increasingly, this problem is coming home to roost.