There’s something of a bubble taking place in the auto loan finance market. How I know this is happening: lenders and dealers are offering 100% auto loans. During the heyday of the mortgage bubble, the mortgage industry had the same product, but it was generally referred to as “zero down.” It’s virtually the same thing, though — buying something without having to make any sort of down payment.
Just as was the case with 100% mortgage loans, there are reasons why you shouldn’t take on a 100% auto loan. Most people don’t realize the problems involved with doing so until later down the line, but if you are considering such financing, you must be aware of the downsides. There are at least seven of them.
1. You Will Maximize Your Monthly Payment
If you take out a 100% auto loan, you will set yourself up for the highest monthly payment possible.
For example, let’s say you’re purchasing a new car for $30,000. If you make a 20% down payment, the loan amount will be $24,000. Assuming a rate of interest on the loan of 3.0%, and a loan term of five years, the monthly payment will be $431.25.
But let’s say you decide on a 100% loan, and finance the entire purchase price of $30,000. On a five-year term, and assuming that the interest rate is still 3.0%, the monthly payment will rise to $539.06.
That’s an increase of nearly $108 per month, or almost $1,300 per year.
Though the 100% auto loan may eliminate the need for a down payment – its primary benefit – it will result in a substantially higher monthly payment over the entire term of the loan.
This is when it’s also important to realize that part of the purpose of making a down payment on anything you buy is to reduce the monthly payment. If you do a 100% loan, you remove that advantage completely.
2. You May Take a Longer Loan Term to Lower the Payments
If you purchase a car with 100% financing, you may be tempted to keep the monthly payments lower by extending the term of the loan. Instead of taking a five year loan, you instead extend the term to 72 months, or even 84 months.
Yes, longer-term loans will certainly reduce your monthly payment. But they come with a host of other problems. This is particularly true of the 84 month auto loan.
The biggest problem associated with longer loan terms is that you actually end up paying more in interest over the life of the loan than you would for a shorter term. For example, a $30,000 loan for 60 months at 3.0% is $539.06 per month. Over 60 months, the total of your payments is $32,343, of which $2,343 is interest.
However, if you take the same $30,000 loan at 3.0%, and stretch the term to 84 months, the monthly payment drops to $396.40. Hooray, right? Except that over the term of the loan, you will pay $33,298 out of pocket, including $3,298 in interest alone. That’s nearly $1,000 higher than you would have paid using a 60 month term.
Perpetual car payments. This is yet another problem associated with long-term auto loans. If you take a 72 or 84 month car loan, you could be setting yourself up to be in a perpetual car payment. That’s because after six or seven years, you may decide that it’s time for yet another new car. If you do this, you will never have the benefit of going even two or three years without a car payment.
3. If Your Credit is Less-than-Perfect, You May Not Get the Loan
Generally speaking, banks and car dealers make their best financing deals available for people who have the best credit. If your credit is less-than-perfect, you may not even qualify for 100% financing.
But don’t lose any sleep if that’s the case – after going through this list, you may discover that’s for the best.
4. You Will Be in an Instant Negative Equity Situation
You’ve probably heard that new cars lose a substantial amount of value just from driving off the dealer’s lot. It turns out that’s true. According to Carfax the typical car loses 10% of it’s value just from you driving the car off the lot. They also typically lose 20% of their value in the first year, and then 15% to 25% per year for the next four years. If you’re lucky, your car will be worth 50% of its original value after five years.
But what that means is that you will be in a negative equity situation with your car loan as soon as you drive off the dealer lot. If you purchased a $30,000 car, with a $30,000 auto loan, and it loses 10% of its value as soon as you leave the lot, you will own a car worth $27,000 that is securing a $30,000 loan. And given that the depreciation continues relentlessly over the first few years, this will create a few problems…
5. You Won’t be Able to Buy a New Car for a Few Years
Car dealers and lenders refer to negative equity car owners as being “upside down” on their car loans. If you use 100% financing to purchase a car, that’s exactly what you will be.
Since the amount you owe on your car will be higher than its resale value during the first two or three years of the loan, you will not be able to buy a new car.
Or can’t you?
If you are unaware of how car sales work, you may be convinced by a dealer that you can buy a new car, even if you’re upside down on the old one. And you can even do it without paying off the deficiency on the old car, or making a down payment on the new one.
How can that happen?
Simple: the dealership “rolls” the deficiency balance on your old car over to the new car. They then arrange another 100% loan on the new car – but it’s actually higher than 100%.
By rolling the deficiency balance onto the new car loan, you may end up owing 110% to 120% of the purchase price (not resale value) of the new car.
That will magnify all the problems that you have in being upside down on your current car.
6. You Probably Won’t be Able to Refinance Your Car Either
Though a car dealer may be able to wave a magic wand by rolling the deficiency balance on your current car over to a new one, lenders won’t be so generous should you decided you need to refinance.
They will most likely insist that in order to refinance, you must first pay down the balance of your car loan to match the value of the car. Depending on your credit history, they may even require that you drop the loan balance even lower.
This means is that if you need to refinance later in order to make payments more affordable, the negative equity will prevent you from doing so unless you can afford to come up with the cash to pay down the loan amount.
It’s a requirement that has prevented many people from being able to refinance their cars. And essentially, this is the equivalent of making a down payment, just later in the loan process (and after accruing interest, of course).
7. You Won’t Be Able to Sell the Car Early in the Loan Term
Few people think about this when buying a new car, but if you fall upon a time of financial distress, you may have to consider selling your car. But if you are upside down on your car loan, selling your car could create more problems than it solves.
If you don’t have the thousands of dollars necessary to pay off the loan upon selling the car, you may not be able to sell it at all. That will lock you into the monthly payment, regardless of your financial situation.
It’s not a comforting prospect to consider, but it does sometimes happen. If you took a 100% loan, you may be unable to sell the car in the first few years.
100% financing is attractive, there’s no doubt about it. You can purchase a brand new car with no money down, and that sometimes enables you to buy a car you otherwise couldn’t afford. Doing this often brings many problems later down the line… the kind you should consider carefully before signing on the dotted line.