The United States is no stranger to problems with over-lending. Most of you reading this are old enough to think back to 2007 and 2008 when the global financial crisis (GFC) caused by American subprime lending destroyed a whole slew of lives. Something as seemingly innocuous as lowering the down payment percentages on houses (it’s much more complicated than that, I know, but let us keep it simple here) had a huge ripple effect across the system.
What’s that got to do with cars? Well let me tell you. We’re starting to see similar tactics used on the housing market back in the car market. Essentially the cars are now too expensive for the average person to buy them, so the wizards up in the banks are brewing new mechanisms to still sell the cars and actually end up making more money. Worse yet, when buying from a dealer vs. a private seller , you often have just the salesperson as the reference point for your banking needs.
The current status quo, maintained by the large dealers , is that the average person buying a car will eventually end up at a dealership to sign the papers and handle the financials. While you can certainly still buy privately , and there are often benefits of doing so, you will likely still have to handle the loan aspect even if you get it directly from the bank. So either way, it is good to be fully prepared.
If you look at things purely from a bank’s point of view - what is the ideal state of someone paying off a loan? Keep in mind that the bank makes money off the amount of money that is still out for loan. At the same time, to avoid losing money on defaults the loan shouldn’t be too much more than the value of the car (this is what is called being underwater on your loan). That leaves the bank’s ‘ideal’ state being where the buyer has $0 equity in the car throughout the life of the loan.
As a buyer, the bank wants you to pay off any depreciation and cost associated with the vehicle, but not too much such that their interest payments drop. Take a look at the example below of a 72 month car loan for a $30,000 new car with a very generous 4% interest. This interest rate is typically for Prime credit score ranges, which is unlikely for those applying for this length loan. We will look into that in a second.
Quick explanation of the chart. The vehicle value in blue starts at $30k at month 0 because it’s a new car. At month 1, however, it drops to about $27,000 because they tend to lose about 10% after driving off the lot. Once you take it, the vehicle is now ‘used’, and sells in a different category. Such is life (I’m writing an article on why to buy used soon but haven’t gotten to it). The loan value in red starts at $27k because it assumes a 10% down payment. Hm. Interesting how the initial depreciation and downpayment are similar. Anyway, the loan is then paid off over the next 72 months and is charted against the depreciation of the vehicle.
I may have ruined the punchline in the explanation a bit, but isn’t it interesting how close the loan value is to the actual value of the car? That makes sense and is one of the reasons why the auto industry would have a hard time ever causing something like the GFC. The loans are asset backed by the intrinsic value of the vehicles. Sure, if we had a mass defaulting of vehicle loans the cars might decrease in value some, but they’re mobile. You can always ship them somewhere that has money and want to buy them - very unlike homes in Florida in 2008. The point is that the bank knows they can get the value back.
They know they can get the value back, and so they want to keep the outstanding loan as close as possible to that value so that the interest payments keep coming. Ok we saw a 72 month car loan now let’s look at what the 84 month car loan looks like over time.
Quick explanation of the chart. The setup here is the exact same as above, except the loan term is 84 months instead of 72.
Let’s focus here on how close the dollars owed on the vehicle is to the actual car value for the first 4 full years of the loan. That means that when this person bought the car, the $3,000 spent as a deposit just disappeared into depreciation. This also doesn’t account for any taxes involved which also disappear. So, they drive off the lot with $0 equity in the car. No matter, they’ll make payments and over time own it! Sadly with this configuration that’s not true. Until about the 48 month mark, this buyer still has 0 equity in the car.
What does zero equity mean?
For those of you who don’t know, zero equity means that if this buyer wanted to sell the vehicle they would have to send all the proceeds of the deal to the bank. Anytime in the first 4 years, this owner would have just been making payments that were essentially doing two things. The first - paying off depreciation of the car. The second - paying interest to the bank.
Why is this a problem?
The main problem I have here is that it is a complicated system designed to convince people that they can ‘afford’ something that is actually an incredibly irresponsible thing to buy. 72 month and 84 month loans on cars should really be called renting because that’s what it is. The bank buys it and then you rent it from them at cost + a service fee. And for the first 4 years, if you stop renting, the bank takes back the car and you’re left with nothing.
It’s one thing if you understand what’s going on and decide you’re ok with just renting the car, but that’s not often the case. Financing through dealers adds huge incentives for the selling party to breeze past the loan details and costs and get straight to signing. True, this happens everywhere sales happen and I’m no anti-capitalist. Shit, I love buying stuff. My family would probably say I love it too much. But the difference between me wasting money on some fancy shoes and others on a long term car loan is that one requires a deep understanding of finance and the other doesn’t.
In an America where few if any children are educated on the inner workings of loans, interest, credit scores, banks, and the infinitely complicated extraneous factors, it is incredibly easy to get caught up and lost in the process. And the result is that we have a huge number of people buying depreciating assets and paying them off at a rate that provides them with zero value.
72 Month Loan Total Interest Variation with APR
Now that we understand how even in good credit conditions we can end up with little to no equity in our vehicles, let's take a quick look at how the APR rates can have a major effect on the overall cost of the vehicle.
Applicant credit score
Average loan APR for new car
Average loan APR for used car
Deep Subprime (300 to 500)
Subprime (501 to 600)
Non-prime (601 to 660)
Prime (661 to 780)
Super Prime (781 to 850)
*credit to Business Insider
If you remember, we started with a $30,000 vehicle and a 10% down payment. In the previous examples we saw a 72 month car loan with a Prime rate of 4%. The table above shows that to qualify for that rate, you have to be in the 661-780 credit score bracket. Assuming that it's unlikely you'd be in this bracket and getting a 84 month loan, let's drop to the non-prime rate of 7%. See the updated chart below.
Here we have all the same inputs for the loan creation, except instead of the prime rate, we got a subprime rate of 7% APR. Notice that the value to loan owned is pretty similar. You still have to pay everything off in 6 years, after all. The big difference here is that instead of $3,414 in total interest over the loan term, you're paying $6,143. That's almost double what a prime-rated customer would pay. Crazy.
Now, you might say 'duh, the interest rate was almost twice as high'. Yes, that's certainly true and should at least fundamentally be obvious. However there are two major clarifications to make on that. The first is that the average person doesn't get quoted what they would get if they had better credit. They only get what they qualify for. So it's not like these comparisons are put in front of them while buying. Second, the total interest is now 20% of the total initial value of the vehicle. Due to extended loan payments we've managed to increase the total car cost by 20%, which is huge. Especially considering the opening remarks that new cars are already past what people can afford.
What's your point?
Most people need a car to get to and from work and do their daily necessities. No one is arguing that. However, I think that if more people fully understood the impact of some of the decisions they make while purchasing a car , they might opt for lower-spec'd vehicles. Rather than focus on the monthly payment, which is what dealers try to talk to you in like it means anything, focus on total vehicle cost. Ask what the cost of vehicle + closing fees + taxes + loan interest will be and then work from there.
If you decide at the end of the day that you still want to buy the vehicle given everything you know, that is absolutely your perrogative. I just hope that you are fully equipped and educated about the details when you do!
Do you have financing questions? Post below and I'll try to write up some answers!
Check out more buying help articles on Car Talk: Transactions
Thanks to investing answers for the loan payment calculators.