Most people like the allure of ultra-low car payments that come with long-term loans. However, staying in debt for nearly a decade just to drive your car is a poor financial choice. You should aim to pay off a 7 year car loan in less than 4 years.
Why people choose 7 year car loans
If you’ve financed your car with a long-term loan, you’re not alone. 72% of new vehicle loans are for 7 years or longer. This wasn’t always true, but as Canadians became more addicted to debt and lenders became more addicted to profit, the 7 year car loan was born. While 7 years is a typical financing term, some car loans are as long as 10 years.
Most people are so financially squeezed they live and die by monthly payments. In order to afford anything, they need to buy it at the lowest monthly payment possible. The easiest way to get the lowest monthly payment without lowering the loan balance or the interest rate is to lengthen the term of the loan.
Long term car loans have made more expensive cars accessible to people who otherwise could not afford them. Where financing $30,000 at 6% of a new car purchase would cost $580 per month on a 5-year loan, that price drops to $438 per month on a 7 year loan. On an 8-year loan it drops again to $394. Since cars still remain status symbols and a way to signal wealth, people use the low monthly payment of a long-term car loan to buy a car they really can’t afford.
The problem with 7+ year car loans
There are a lot of problems with 7 year car loans, but three in particular stand out:
You owe more than the car is worth for most of the time you own it.
The only thing that depreciates faster than a new car driving off the sales lot is cryptocurrency in 2018. You can expect your new car to lose 20% to 30% of its value in the first 12 months, during which you’ll pay off less than 10%. In other words, you don’t own really own the car you just bought. The bank does.
After the first year, you can expect your car to depreciate 10% per year for the next 4 years. Meaning a 5-year-old car is only worth about 40% of its original purchase price. When you take out a long-term loan, your payments don’t keep up with depreciation. You will end up owing more than the car is worth for years. This is called being “underwater” on your car loan.
Being underwater on a loan is a precarious financial position because it means that you cannot liquidate an asset to pay off a debt if you needed to. For example, if you were to lose your job, selling your car would not eliminate your entire car loan. You’d still have to make payments on whatever balance you owe, even though you have no vehicle to show for it!
The car ages, but your loan payments stay the same.
When people finance a new car, they only think about their loan payment in the context of paying for that new car, not an old one. However, your new car will eventually become old.
The average car payment in Canada is $479 per month. While a $479 monthly payment might feel like a deal on a brand new vehicle, it won’t feel that way when your car is 5 years old. But you will still be paying $479 in year 5. And years 6 and 7 for that matter, if you finance that long.
Imagine someone tried to sell you a 7-year-old car for $479 per month. Would you buy it? If the answer is no, why are you buying it now by signing on for that loan term?!
You will be lured into an eternal debt trap
Unfortunately, most people will actually not be making their regular car payment on that same car in year 7.
Around year 5 or 6, they’ll get bored with their current ride and trade it in for a new vehicle. Since they’ll still be owing on their car loan, they’ll roll the remaining balance, called “negative equity”, into a new car loan, effectively never getting out of debt. Some who trade in for a new vehicle before year 4 or 5 might actually never get out from underwater of their car loan — meaning they always owe more than their car is worth!
You can avoid all the above headache by simply committing to pay off a 7 year car loan way ahead of schedule.
This is how much you REALLY should be spending on your car
Your cost of car ownership is not merely a car payment. It includes gas, insurance, maintenance, repairs, and other expenses, like parking and winter tires. Those extra costs are one of the reasons most car owners are notoriously bad at underestimating their vehicle costs.
The bill? Your total transportation costs should be less than 15% of your net income.
The total of all your transportation expenses, from your vehicle loan payment to the odd speeding ticket, should amount to less than 15% of your net take-home pay. For example, if you take home $3,000 per month, then your monthly transportation costs should be no more than $450. That’s $450 for everything, not just your car payment. If you’re going to be spending $100 month on gas and $70 per month on insurance, you can’t actually afford a car payment more than $280 per month. Of course, the car dealership will tell you otherwise.
Remember: your car salesman only cares that you buy the car and drive off the lot, not what happens to your long-term financial security after.
Already stuck in a 7 or 8-year (or longer) car loan? Read on to find out how to get out of it.
The Ultimate Debt Hack: you don’t have a to make a whole extra car payment to make an extra car payment
Paying off your long-term car loan is easier than you might think. All it takes is a little bit of wiggle room in your budget and some discipline, and you’re all set.
When you make a car payment, particularly on a loan with a longer term, an obscene amount of your payment goes towards interest. Often as much as 1/3 of your regular car payment is paying interest, and the remaining 2/3 goes towards the principal balance. However, when you make an extra car payment, 100% of the payment goes towards reducing the principal you owe.
Therefore, you can make a smaller extra car payment, and still knock a full payment of your loan term.
Imagine your car loan as a series of equal payments, from now until your vehicle is paid off. When you make an extra payment, you are really removing a future payment from the end of your loan balance. Nothing changes at the front end, all the payments remain the same, but you have one less payment in the future.
Take a minute to imagine yourself 7 years from now. Walk up to your future self and say, “Hey! Guess what? you don’t have to make a car payment this month!”. How does your future self react? I imagine they’re as happy as if someone told you right now that you don’t have to make car payment this month! This is the gift you can give yourself.
Make extra payments for 3 years, but get out of debt more than 3 years faster
In the title of this post I promised you that you could pay off a 7-year loan in less than 4 years, but why exactly does paying only half as much as your monthly payment get you out of debt twice as fast? Because even though we did a 1-to-1 payment analysis above, you are actually getting much further ahead than that.
Because every extra payment goes towards the principal balance owing, reducing the balance ahead of schedule also reduces the amount of interest you’ll pay over the lifetime of your loan. As a result, you’ll actually be debt-free sooner simply because you’ve saved a ton on interest.
Pay off a 7-year car loan in less than 4 years
Let’s say you buy a used car and finance $25,000 at 6%. You pay bi-weekly, so over the lifetime of the loan you have 182 equal payments of $168.38. That doesn’t seem too bad!
When your first payment comes due and you pay $168.38, only $110.69 goes towards the principal loan balance. The remaining $57.69 goes towards interest. That’s a full 34% of your payment!
But wait, it gets worse. Because you’re on a bi-weekly schedule you’ll actually have to make a second payment this month, which means you’ll spend over $100 per month on interest in just one month. Gross!
This doesn’t have to be your life. You can get ahead of this loan, start building more equity in your car, pay less interest, and get out of debt faster by doing one simple thing: making an extra payment.
The best part? You don’t have to pay an extra $168! Instead, you can just come up with the extra $111 that goes towards the principal. Finding an extra bi-weekly $111 (that’s $55 per week or $222 per month depending on how you think of it) is all you need to get out of debt years ahead of schedule and cut your interest costs by over 20%.
In the example discussed above, the $25,000 car financed at 6% over 7 years will cost you $5,645 in interest over the lifetime of the loan. Commit to making the extra $111 payment on top of your regular payment, and you’ll only pay $3,035 in interest. That’s $2,610 in savings! This is equivalent of 15 (FIFTEEN!) regular bi-weekly payments of $168.38.
How to find the extra $$$ for extra car payments
If the above all sounds well and good, but you’re not exactly sure where you’re going to find the extra cash to make an extra car payment, don’t fret. Here are a few steps you can take:
Break the amount into small weekly payments, and make those instead. One of the challenging things about paying off debt quickly is that big payments feel… well, big! If you can break them down to smaller but frequent payments, it still is the same amount but it will feel more manageable. Try making it a weekly payment. Set up an automatic transfer from your chequing account to your loan to happen every Tuesday or Thursday (this avoids long weekend holidays!) and you’ll pay even less interest with these frequent transfers. Here’s why this simple hack is such a game-changer.
Round-up your spending to the nearest $5 or $10 and save the difference. I use KOHO to round-up every purchase I make to the nearest $5 and tuck the extra away in a savings account, but many big banks have debit cards with this functionality, too. Once your round-up account accumulates the weekly or bi-weekly amount you need, transfer it to your loan! Want a little extra to begin? You can get $20 in free money by signing up for KOHO with this link.
Use cash windfalls to make big dents in your loan. Maybe your budget really is too tight to find a full extra payment towards your car loan. If this is the case, pay what you can and then make a bigger payment towards the balance when the opportunity arises. For example, if you get $1,000 back on your income tax refund and put it towards your car loan, this is the same as making five extra payments of $200!
Being in debt sucks. Avoid long-term debts when you can, especially if they’re for depreciating assets like a car. If you’ve already roped yourself into a lengthy vehicle loan, start taking your life back by making extra payments. It is possible to pay off a 7-year car loan in as little as 4 years, but only if you start right now!