Think Twice About the Seven-Year Auto Loan

Here’s a lousy new consumer trend: the seven-year auto loan.

While experts typically recommend consumers take out loans no longer than four years, six- and seven-year loans are becoming increasingly popular.  Indeed, of those who took out an auto loan in 2008 43% were of six- or seven-year durations, up from 32% in 2004, according to J.D. Power and Associates. While consumers may welcome the lower monthly payments that come with long-term loans, they usually don't make financial sense in the long run.

What's driving this trend? Low monthly payments, says Ralph Ebersole, director of automotive consulting at Cars.com. Many drivers decide if they can afford a car by assessing the monthly payment. By lengthening the terms of the loan, the payments decrease significantly. Someone buying a $30,000 sedan can cut his monthly tab from $720 a month with a four-year loan to $475 a month with a seven-year loan, according to LendingTree.com. Auto makers are also trimming their leasing business after experiencing significant losses and are trying to convert their current customers into folks who finance their automobiles. One way to do that is to get the monthly loan payment to match a lease payment.

Still, these loans are riddled with problems. First, they're quite expensive. Not only is the consumer making more payments, he's also charged a slightly higher interest rate since these deals are riskier for the lenders. While a driver with good credit can expect a 7.1% interest rate on a four-year loan, the rate jumps to 8.5% for a seven-year loan, according to LendingTree.com. On a $30,000 sedan, that means a consumer will pay $5,300 more in interest on a seven-year loan vs. a four-year obligation. "If people added up the total payments many people would be appalled at the extra money they'll be putting up for those extra years," says Jack Nerad, executive editorial director and market analyst for Kelley Blue Book's kbb.com.

Another problem is that most drivers start to crave that new-car smell after four years, says Jessica Caldwell, industry analyst for auto web site Edmunds.com. Should someone try to trade in their vehicle before their seven years are up, they're likely to owe more to the bank on their financing than the car's worth on the open market. This is a situation the industry calls being "upside-down" on one's loan. It happens because cars depreciate faster than an owner pays off a long-term loan. A car can lose up to 50% of its value after just three years, says KBB.com's Nerad.

Drivers could also wind up upside-down if they get into an accident and the car is considered a total loss. Even if a consumer has comprehensive auto coverage, he's still only going to get the current replacement value for the vehicle from the insurance company, not how much is owed to the bank, warns Cars.com's Ebersole. Sadly, that often leads consumers to make an even worse financial decision: They roll what they owe on the existing loan into financing for a new car. Now the driver owes more on the new loan than the vehicle is worth before he even drives off the lot. "You're just compounding the problem and at some point you have to pay the piper," says KBB.com's Nerad.

Despite these warning, some drivers may still consider a long-term loan. Here are a few ways to make the best of it:

Hold on for the long haul
The only way to justify a 72- or 84-month loan is to keep the vehicle for the entire six or seven years. "Then at least you're fulfilling your financial obligation to the finance company," says Nerad. If you can, though, you should hold onto it longer than that so you get some payment free drive time.

Treat your car right
The monthly payments aren't the only costs associated with a vehicle. Regularly scheduled maintenance checks and necessary repairs can also add up -- and tend to get more prevalent and expensive as the car ages. To keep additional costs to a minimum, consumers should consider automobiles with longer than average warranties (Hyundai and Kia guarantee the drive-train for 10 years or 100,000 miles) or cars that are known for high reliability, such as a model from one of the Japanese auto makers. It's also a good idea to buy a vehicle that depreciates slowly. Luxury vehicles, for example, tend to hold onto their value better than a typical SUV or truck.

Consider gap insurance
Since there's still a chance a driver could end up "upside-down" if he gets into an accident, purchasing gap insurance is a good idea. For about $400 a year a consumer can purchase an insurance policy that protects against the risk of owing considerably more to a finance company than a car's replacement value if the vehicle is totaled. While this is typically a product that's sold to lease customers, it makes sense for long-term borrowers too, says Ebersole.