Debt Traps: What to Watch Out for When Considering an Auto Loan

With about 64 percent of adults in the United States driving daily, cars are a necessity for most people. However, over the course of the last few years, the prices of cars have been rising, while wages have been slow to catch up. Causing more and more Americans to lean on auto loans to cover the cost of transportation, the auto loan industry has expanded rapidly over the last decade. Over the past ten years, the average price of an auto loan has swelled by roughly a third to around $32,119. Meanwhile, debt is tricky enough without adding extra payments you don’t need. American household debt (as well as national debt) is already at record highs. So what can you watch out for to avoid falling into deeper debt than you absolutely need to at the dealership?

Long Loan Terms & Packing Payments

With the cost of financing skyrocketing, more and more would-be car buyers are finding the payments difficult to manage. In response, dealerships are turning to longer-term loans. In 2010, the typical loan term for a car was five years, or 60 months. Today, sellers are offering up loans with term lengths that last around 70 months on average, with a large portion of loans even stretching out over the course of more than 85 months, and some even spanning greater than nine years. This means, for many buyers, that they’ll still be paying off the car by the time they’re ready to sell or trade it in. More buyers than ever, subsequently, are rolling over old debt into new loans after their first car has worn out. According to Edmunds, about a third of the new loans issued at the beginning of 2019 were for longer than six years, whereas a decade ago that figure was around ten percent. The other problem with these long loans, meanwhile, is that, because of their length, buyers are paying exceedingly more for the vehicle than if they had used a shorter-term loan. Add to that the fact that many dealerships are marking up their interest rates, sometimes even by two or three percentage points, and buyers are faced oftentimes with payments that they did not expect and can’t afford. A car dealership today makes more money from the auto loan than from selling the car itself. In the past, a sale brought in more than one and a half times the amount of financing, while – according to Forbes – last year, dealerships made roughly $932 on finance and insurance, and just $331 from the actual sale of a vehicle. The customer, meanwhile, can walk off the lot already being underwater on their car, obligated to pay more over the life of the loan than the car itself is actually worth. In addition, by the time the car is old enough to need potentially expensive repairs, like new tires or brakes, they’ll have to shell out money for those costs while still covering the cost of their monthly loan payment as well. 

Another trend that has emerged is that of “packing payments.” It’s illegal, but that doesn’t stop dealerships from doing it. Packing payments describes a situation in which the dealership automatically includes extras or add-ons in an inflated monthly payment. Because these services – which would normally be optional – are already bundled in, the dealer gets a bigger payout without giving the buyer the choice to refuse. This is while offering the buyer what they claim to be “free” or “discounted” extras. For a buyer, agreeing to such a rate for such a long amount of time simply puts large amounts of extra cash in the dealers’ pockets, while – again – ratcheting up the monthly cost of a car to levels that might put a buyer’s finances at risk.

Auto Loan-Backed Securities

It doesn’t make a lot of sense that dealers would offer rates to customers that they can’t afford. However, in many cases, the sellers of the loans aren’t the ones necessarily taking the risk that their customer will default. After a deal is closed, various financial institutions will usually buy up the loan, packaging them into bonds through securitization for sale to investors. These may be fixed-income investors, such as pension or other retirement fund managers, with investors last year buying up a record $107 billion of auto-backed bonds. Paying the bondholders a certain amount of interest, usually paid twice a year, for taking the risk of holding the bonds – while the bondholders expect to get interest payments and eventually be paid back their principal as well – the risk of default is transferred from the issuer to the bondholder. A customer buying a vehicle wouldn’t be at risk regarding these securities, but it doesn’t give the dealership any extra incentive for making sure they offer the buyer a reasonable financing deal that will ultimately work for them. This puts the onus on the buyer to make sure they do their own due diligence in keeping their payments manageable. 

How can you avoid financing pitfalls?

The best way to avoid these traps at the dealership is to secure your own financing in advance. Getting a preapproval from your own bank, credit union, or even an online lender can give you an alternate financial option in the event the dealer doesn’t offer you a deal you can afford. Meanwhile, having a lower, reasonable rate that you can fall back on if you need to can prompt the dealer to offer you their best rates. With dealerships often in a position to present even better deals, having a fallback option in your arsenal can put you in the position of power during your negotiations. This will also prevent you from being subject to the offer on the table and thus potentially bullied into a monthly payment that may put your finances in jeopardy later – not to mention waste you a lot of money, at best.

Buying a car can be a tricky process. It’s often emotional, as well as stressful, because, to begin with, a car is a high-cost purchase. If you’re buying a vehicle, you’ll also want to watch out for hidden fees and avoid paying for extras you don’t need. A good rule of thumb is to simply ask the salesperson directly for an “out-the-door” price. As with any purchase, you’ll want to be careful of the fine print and ask about any surprises you don’t understand. However, long-term loans, in particular, are a relatively new development that can trip you up if you’re not ready for it. With auto loans at a record high of $1.3 trillion as of June 2019, lenders are raking in high fees, while buyers may pay the price if they’re not careful. 

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