More Americans than ever before are taking out very long loans to buy new cars. Long-term loans -- classified as six years or longer -- made up a record 33.1 percent of new vehicle retail sales in February, according to J.D. Power.
But is it a good idea to take out a car loan that long? If you need more than a four-year loan, you are probably about to buy a car that is more expensive than you can really afford, says managing editor Mike Sante of personal finance web site Interest.com. "Too many people show up at a car dealership with only a vague idea of what they can afford to be spending," Sante told CBS MoneyWatch.
To show what a problem affordability can be, Interest.com did a study released today looking at whether a family with a median income could afford the average-priced car -- recently $32,086 according to Kelley Blue Book. Of the 25 largest U.S. metro areas, only in Washington, D.C., where the median income is $88,233, could that hypothetical family afford the average car. In Tampa, with last-place median income of $44,402, the median family could afford only a total purchase price of $14,209, which likely means buying a used car.
In the calculations, the website used financial planning guidelines of a 20 percent down payment, a loan of four years and monthly payments, including insurance, of no more than 10 percent of gross income.
Let's look more closely at those guidelines, a good starting point when you are shopping for a car:
- Down payment. Paying 20 percent or more up front is a better way to reduce payments than extending the loan. Since a new car depreciates most heavily it its first two years, that down payment also could keep you from owing more than the car is worth if you have to sell it or if is totaled in an accident and the insurance settlement is only for the current value of the car. The 20 percent does not have to be all cash. It includes the value of a trade-in, if you have one.
- Four-year maximum. Having this limit helps you control your total spending. The longer the loan, the more you pay in total interest even at a low rate. And it limits the price of a car you really can afford. "If you just go into a dealer and say you can afford $400 a month in payments, he will put you into the most expensive car he can and finance it over a longer time, cautions Sante.
- The 10 percent of income limit. Even starting with this sound budgeting level, there are pitfalls. People often forget that if they move from an older car to a new one their insurance bill will rise sharply. Get an insurance quote from your agent or online before you start planning your car purchase so you are working with realistic numbers.
To help you make these decisions, look at the Interest.com calculator that will let you figure out how much you can spend once you put in your affordable monthly payment and the available interest rate. And don't forget local sales tax and fees in working out the total.
If you can, get a financing commitment before you go car shopping. Then you won't have to depend on dealer financing. But you could still take it if the dealer's finance office offers a better rate than your bank or credit union.
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