How to determine car loan length as a function of how long I plan to keep a car

Question

I will be financing* the purchase of a brand new car that I plan to keep for 3 years. Based on this I am trying to understand how to structure the loan variables (term, rate) appropriately.

Should I get a loan that lasts only as long as I plan to keep the car? Or how should I think about this? One problem with getting a 3 year (36 months) loan is that my payments are very high.

So I am looking for advice on how I should be configuring my loan.

*Note: A lease is not an option in this case.

UPDATE: I wanted to provide more context to my question. I'm already decided that this car will be brand new and I will keep it for a limited period of time, e.g 3 years. Those are not variables that will change. For the purposes of this question I am thinking of this car as one might consider a Tesla (although it is not a Tesla) - that is, I have the following ideas in mind:

• I am buying a piece of technology on wheels (similar to a Tesla) and as such it's future value is highly unknown, given the pace of tech
• I am an early tech adopter and since tech moves so fast, I am going to want the latest and greatest version of that model after this one. That's why I plan to hold for a short period of time.
• For the purposes of this question I am not considering a lease as an option.

Answer 1

The general advice for this site the shortest loan period and the largest down payment; this makes sure you aren't under water and your interest costs are low. This means that the best loan options are for 0 months and 100% down.

The advice is to purchase a car that isn't new. The idea is to get those cars coming off lease after two or three years. It is also possible to buy a car that is even a little older.

The advice from this site is to drive the car for as long as possible. But because you only want to drive it for three years, getting a moderately older car so that you have missed the steep decline in value at the start, and get rid of it before the number of repairs becomes large.

If you must finance, then setting a goal to pay off the loan in three years will simplify the selling of the car when you want to get rid of it.

Answer 2

A car is not an investment. Cars drop in value over time, so you should not put yourself in a position to ever owe more than the car's worth. Most new cars drop in value by 20-30% in the first year, and 10% per year after that. Many experts recommend buying a car that's at least 2-3 years old and never financing a "new" car.

That means that you should put down as much upfront as you can (ideally 100%) and get as short a loan term as you can afford.

So 100% down is the best decision, and 0% down for 7 years is a horrible decision. You decide where on that spectrum you want to be.

Note: A lease is not an option in this case.

Good. Leases are an incredibly expensive way to operate a car. You're essentially renting the car, and the payback amount is usually more than what the car's worth. They count on people being willing to may more than it's worth to avoid the hassle of finding a replacement or out of sentiment.

Answer 3

There are a handful of things to consider when trying to determine term for something like a car loan. For the purpose of keeping this on topic and about finance, vs personal preferences or decision making about cars in general, let's assume you've chosen a vehicle, or a type of vehicle at least, and you have an idea of about what the purchase price will be - and you are able to afford that purchase price. That leaves the following considerations:

• What interest rate are you willing to pay? Generally, longer-term loans have higher rates. This is essentially tied to the expectation that vehicles (as financial assets) are less predictable as they get older. If you are not willing to pay a high interest rate, generally you should keep the term short.
• What monthly payment can you afford? As you identified, shorter terms means the monthly payment is higher. If you can only afford a certain payment, that may mean you need to think about a longer term (or, a cheaper car - although that's potentially outside the scope of the assumptions mentioned above).
• How do you expect the value of the car to change over time? This is a hard factor to predict, but if you're buying a vehicle from a brand that tends to hold value well, and you tend to treat your vehicles well in terms of maintenance, it may be more likely to hold value longer, versus a less-reputable brand or a less-reliable vehicle. Generally, you should try to ensure that you don't end up upside-down - that is, owing more than the car is worth. If you do well at shopping (versus paying too much for a given vehicle), buy a brand known to hold value, and keep the term short, you are much less likely to end up upside-down. Bonus points for paying as much as you can afford for the downpayment, since this will both further prevent you from being upside down, and will significantly reduce the amount of interest you pay.

Noteworthy is the fact that "when do you plan to sell the vehicle?" isn't typically an important consideration. If you do your best to ensure that you don't end up upside down in the loan, it's generally not a problem to sell the vehicle before the loan term is up. In fact, that's the most common scenario - the majority* of auto loans are closed prior to their term expiring, because the individual sold the car (and paid off the loan).

*(The actual percentage is between 60 - 70% depending on the type of loan. The average age of a loan when it's paid off is between 28 - 34 months.)

Answer 4

One problem with getting a 3 year (36 months) loan is that my payments are very high.

The typical advice is, don't buy a new car, and don't keep a car for such a short period of time. It is not financially prudent. Buying used and running it into the ground will almost always be

That said, the math will be based on interest rate and depreciation over 3 years. If you do a 36-month loan then when you sell it in three years you'll keep the proceeds, a 60-month loan means you'd owe the bank a chunk when you sell, as long as you can sell for more than you owe you won't have to come up with extra cash at that point.

The never finance a car advice is typically sound, but there are times when rates are low enough that it can be economical. For example, when I purchased my last used car they were offering financing at 0.9% interest on new vehicles and 1.9% on certified pre-owned. CD rates at the time were ~3%, so financing made more sense than paying cash. In such cases it also makes sense to finance for the longest term allowed.

If you are dead-set on a new car and only keeping it for 3-years and can't secure an incredibly low rate, then choose the shortest term to minimize interest cost, and if the payments are too high, choose a less expensive car or wait until you can put more money down.

Answer 5

Once you have settled on the car and the price you can ignore it. You have written a check to buy the car, which makes your balance negative. You need to solve that problem. You are borrowing a sum of money (which happens to be about the price of the car) for three years. Three years from now you will receive some money from selling the car. This can be used to pay off any residual value of the loan, but may not be enough or there may be excess depending on the loan you select. Borrowing against the car gives the lender assurance of being paid, which will reduce the interest rate compared to other loans.

The less you borrow the less you will pay in interest. A shorter term loan will reduce the balance faster, resulting in less interest to pay. The interest rate may also be lower if the loan is shorter. If you get a larger or longer term loan, you will have more cash in your checking account which can help with future financial issues. You need to decide how much liquidity is worth to you, because that is what you are paying for with the extra interest of a longer or larger loan.

If you take a shorter term loan, the extra payment is essentially a savings account that you will redeem in three years. If you pay an additional $100 per month at the end of three years you will receive $3600 plus interest more when you sell the car and pay off the loan. If having that $100 disappear from your checking account causes you to forego other purchases, you will be that much cash better off.

Really this question is not about a car loan, it is about alternatives in light of your whole financial picture. A shorter term with a higher payment is the conservative alternative, because it is creating an asset in the future. A lower payment leaves you more fragile because at the end of three years you may need to come up with money to pay off the loan.

Answer 6

Even a car manufacturer does not give a 7-8 years warranty, which means there will be heavy maintenance expenditure after the initial 3 to 5 years of purchase.

The average use of a car is not more than 5 years before the first time buyers sells it to a second-hand user, the long term loan will be a hassle since the buyer will continue to repay the outstanding loan on the car even after completing 5 years. Here's an article on car loan tenure that I found which can be helpful for you to decide.

So, the higher maintenance expenditure coupled with the EMI can result in a heavy financial burden for you.

Answer 7

Note anything you plan to do now (such as changing after the 3 years the car to the latest and greatest car), can change in the future (such as becoming unemployed and thus aborting the plan to buy the latest and greatest car and continuing with the current car).

One option could be a loan with larger final payment and guaranteed value of the car for the end of the loan period. I'm not sure if all car companies offer such flexible financing, but at least where I live, Toyota offers loans with larger final payment and guaranteed value of the car (equal to the final payment). In your case, such a financing could be an attractive option for financing the car.

However, there are several downsides:

• If you buy a car, you need some downpayment in practice. If the final payment of the loan is equal to the guaranteed value of the car, you won't have any money for the next downpayment if you're planning to buy an even newer car

• If your plans change, and you decide to keep the car, and if the loan is from the financing company of the automaker, you have to note that the automaker is in the business of selling cars primarily and only secondarily in the business of financing them (due to necessity; not many people will buy cars if there's no financing available). They don't have big incentives for accepting an extension for the loan in case you want to keep the car. They really want you to buy an even newer car.

I bought a new car in 2016 with 4-year financing, a large downpayment, and large final payment equal to the guaranteed value of the car. In late 2019, I was considering buying a Tesla but my plans were made somewhat difficult as the the large final payment equal to the guaranteed value of the car meant I had to find the next downpayment from somewhere. A large next downpayment would mean selling all my stock ownerships, for example, which I didn't want to do.

Then in 2020 I bought an electric bicycle and started riding bike again after a long period of not riding bike, meaning a Tesla would no longer be cost-effective due to the reduced amount of driving with a car. I decided to keep the car, but again, finding the money for the final payment would mean selling a huge fraction of my stock ownerships, which I didn't want to do. I tried to arrange extension for the loan from the automaker financing company, but soon find it was of no use -- they said they can extend the loan only after the second-last payment (meaning there's only 1 month of time to arrange the extension), can extend the loan only one year at a time, and every time the loan is extended there will be a large fee. Fortunately, I found that my bank offers cheap consumer credit for those in a strong financial position such a lots of stock investments, so I decided to replace the automaker financing company loan with a bank loan.

So, lessons learned:

• Keep in mind the need to have money for the next downpayment, if you plan to buy an even newer car instead of ending car ownership
• Remember that if you take a 4-year loan with large final payment, the financing company don't have to agree to a 4-year extension, so a 8-year loan is much better than a 4-year loan with large final payment - except nobody is offering 8-year consumer credit.