Sunday, June 10, 2012

How to Determine the Right Length of an Auto Loan Term

The length of auto loan term you choose for your financing will affect all other facets of your loan. This includes rate, monthly payments and flexibility of terms. The length of the loan you choose will also determine how quickly you can build equity in the car, which is a large consideration with used car purchases. Know your desired length before going into negotiations based on these factors.

Length and Interest Rate
Interest rates tend to be lower on shorter loans. When you pay a loan back quickly, there is a lower chance your financial situation will change in a way that prevents you from repaying the debt. There is also a lower chance inflation will be a large factor in the profitability of the loan for the lender. Ultimately, if you would like the cheapest loan possible, it is best to elect a short-term loan like a 3-year or 5-year auto loan.
Length and Monthly Payment
Choosing the length of your loan is not as simple as just opting for the shortest term, however. You must also consider if you can afford the short loan. When you are paying down a large sum of money, you will have to pay very high rates monthly in order to meet a short-term loan contract. This can be very burdensome for borrowers with lower incomes. One way to counter this problem is saving for a high down payment. This will lower the limits of the loan you need to take, meaning you can pay the loan off faster without having very high monthly payments.
Length and Flexibility
Auto loans from dealers tend to be very rigid. This means you will not be able to prepay or refinance without large penalties. Auto loans from banks may be more flexible, but they can still be difficult to rearrange if need be. The longer the loan you take, the more likely you will need to rearrange the debt in the future. This can occur if your job or income changes. Lenders know this, so they will build in less favorable terms on long loans to prevent you from changing the loan down the line. You will generally find more options to prepay or negotiate a shorter loan.
Length and Equity
When you make high monthly payments, you build up equity in the car much faster. This prevents the possibility you will have an upside-down loan. In an upside-down loan, you owe more on a car than it is currently worth on the market. This is particularly concerning with a used-car loan. Used cars depreciate in value faster than new cars. You should aim for the shortest loan term possible on a used car to prevent having negative equity in the vehicle. Even new cars can slip into a negative equity situation in a loan term of 7 or more years. If you elect a very long loan, make sure your down payment is high enough to protect you against a negative equity loan so you do not risk exposure to increased liability if you default on the loan.


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