Long Term Auto Loans a Ticking Time Bomb

What we have is a cash flow problem in this country. Consumers are strapped for cash and looking for ways to buy their necessities any way they can. We are also finding another debt bubble ready to implode; however, this time it could be in the auto loan industry. Some banks are offering 8 or 9 years amortization for car loans – great for cash flow, bad for the industry.

You say, so what? Well, think what happened with the subprime domino effect and what the ramifications are now for the consumer who has great credit trying to get a home loan. Consumers with great credit are finding it hard to get loans; they’re being penalized for the loose restrictions in the past for those with bad credit. The same thing is being set up with lenders who are giving out 8 or 9-year car loans. The auto industry needs to sell cars. However, at what cost? A car’s asset value will be worth less than the balance of the loan by that time it is paid off.

A car is one asset that will lose its value the moment you drive it off the lot by about 20%. So let’s assume an average car costs about $18,000. Once you drive it off the lot it’s now $14,400.

An average car loan today is 7%. Let’s amortize that loan over a 7-year period, which is a loan period borrowers can easily get today. Your payments are around $271 per month. If you took that same car loan and paid it off over a five-year period, the car payments would be $356 per month. Great cash flow! However, let’s see what happens if you held that car for the full term of a 7-year loan.

According to the car industry regarding depreciation of autos, a two year-old car will be worth 80 to 85 percent of its 1-year-old value. A 3-year-old car will be worth roughly 80 to 85 percent of its 2-year-old value, and so on. Using the worst-case scenario of 80% value per year, as soon as you drive your car off the lot, that $18,000 car is worth $14,400. By year 2 it’s worth $11,520. By year 3: $9,216. The 3rd year you still owe $11,344 on a 7-year amortization loan. The following years the car depreciates quicker than you are paying off the balance of the loan. Hmm, what’s wrong with this picture?

What is wrong is a consumer with bad debt might just want to walk away from the car loan balance if he keeps taking on more consumer debt. He’s done it before and will do it again, leaving the banks high and dry while consumers with good credit pay the price, just like we are doing in the housing market.

There is nothing wrong with holding onto a car that long. I have held onto 2 vans for 12 to 13 years before giving them up. I’m a firm believer in running vehicles into the ground and getting my money’s worth. However, you really have to love that car for that time period because you have to remember how much it will cost you in repairs after your warranty expires.

This cycle of sucking the consumer into the claws of debt has to stop. Sooner or later, we will all pay the piper.