The 7-Year Car Loan: Watch Your Wallet

Enlarge this image toggle caption Courtesy of Laura Hart Courtesy of Laura Hart

A couple of years ago, Laura Hart had been through a divorce, her car was 11 years old, and she wanted a new vehicle. "Almost, 'I earned it,' really" is how Hart says she felt at the time.

She'd been through a tough experience "while maintaining a full-time job and raising two kids and things like that, so when I got to the point where I felt comfortable to take on a car loan again, I was fairly proud and ready to do that."

Hart is a grade school principal in Clovis, Calif. And having kids, she wanted better safety features. She decided on a new Jeep Cherokee.

She spent almost exactly what Americans are spending on new cars on average these days — $37,782, according to the car-buying site Edmunds. Americans are buying bigger, pricier cars with more options. And one thing driving this trend is dealers offering car loans with seven-year terms.

A seven-year car loan means lower monthly payments than a three- or five-year loan. That sounded good to Hart. And she's not alone. A third of all new car loans now have terms longer than six years, according to the credit reporting company Experian. That's more than three times as big a share of the loan market as a decade ago.

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But while these loans are popular, they're probably not the best personal finance move.

"The long loan terms are a really dangerous trend," says Philip Reed, autos editor for the personal finance site NerdWallet. He has written books about car buying and worked undercover at a dealership for several months to learn more about the car-buying process when he worked at Edmunds.

"When most people go to buy a car, what they look at is the monthly payment, which is in itself a big mistake," Reed says. He says car dealers know that if they can make the payment look affordable, people will think it's a good deal.

"But it doesn't really work that way," Reed says. For one thing, with seven-year or sometimes even eight-year loans, "you're going to pay an enormous amount of money in interest," he says.

Longer-term loans usually have higher interest rates — and you're paying longer, he says. So Hart's Cherokee will likely cost her upwards of $2,000 more in interest than a five-year loan would have.

And if you want to sell your existing car — maybe you have another child and need a minivan — with a seven-year loan you are much more likely to be stuck still owing a lot more than the car is worth, Reed says. "It puts you in a very sort of vulnerable financial situation," he says.

For new-car purchases with a trade-in, about a third of people are now rolling over an average of $5,000 of debt from their old car loan into their new car loan, according to the Edmunds site. In other words, they're still paying for a car they no longer own.

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Some economists say many Americans are stretching themselves a lot more than they have to. Cars, like most other things, get more expensive over time. But inflation is only part of the story. If you compare a car from a decade ago to a similar car today, prices of similar vehicles haven't gone up nearly as much as prices on cars people are deciding to buy.

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In other words, "people have substantially upgraded the vehicles they are buying," says economist Donald Grimes at the University of Michigan, who studies the auto industry. He says Americans are deciding to buy bigger, fancier cars with more options.

"They are now much more likely to buy an SUV, pickup truck, or crossover SUV and much less likely to buy a small sedan," Grimes says.

Grimes says rolling over old car loan debt into new car loans suggests that many people can't afford the vehicles they're buying. And he says the prices they're paying are rising faster than wages.

Adjusted for inflation, "real-dollar spending on new cars and trucks has gone up by $5,299 over the past 10 years," says Grimes, "while the real annual wage has gone up by $3,646."

So, Grimes says, seven-year car loans appear to be encouraging many Americans to overspend. These longer-term loans are also helping dealers pack in more pricey extras.

John Van Alst, a lawyer with the National Consumer Law Center, says that when you're buying a car, "you've probably spent already maybe hours at the dealership choosing your car — maybe negotiating with the salesman on the price of the car itself — then you're led to this back office. They'll often refer to it as the box."

That's when car dealers tell you the loan options and try to sell you add-on products: extended warranties, gap insurance, tire protection plans and paint protection plans. Dealers make a lot of money on those. Van Alst says these are often dramatically overpriced, and most car buyers don't know what a reasonable price is.

"Is this add-on, you know, being marked up 300%? You don't really know any of that," Van Alst says. And with a seven-year loan, he says there's more wiggle room to throw in these add-on products without bumping up the monthly payment that much.

The National Automobile Dealers Association had no comment.

When Hart bought her Jeep, she agreed to buy an extended warranty and other extras, adding $2,700 onto her loan.

Hart likes her car, and in her case she didn't dramatically overstretch. But she has a bit of buyer's remorse since she'll be making payments for so long. And now she says that if she hadn't gotten the seven-year loan, she certainly wouldn't have agreed to those pricey add-ons.

As for the car itself, she wonders, "If the loan had to be five years, what car would I truly have driven off the lot that day?"

Odds are, something cheaper.