A reader once called me out on my advice about car buying.
I had suggested that if you can't pay cash for your next car, you should make a down payment of at least 20%, finance the balance for four years or less and make sure the resulting payment is no more than 10% of your gross income.
This reader did the math and sputtered, but that means the typical American family can't afford the typical new car!
Precisely.
Someone who purchased a new car last year, when the average price was $28,966 according to the National Automobile Dealers Association, would have needed a household income of nearly $65,000 to swing a purchase under my formula. That assumes a 5.75% interest rate, which Edmunds.com says was the average paid by buyers who financed new cars in 2009. The latest statistics from the Census Bureau show median household income was about $50,000 in 2008. "Median" means half of all U.S. households earned less.
Car dealers have been pretty clever about disguising the fact that most households can't afford their new cars. They do this by:
- Stretching out your loan term. Nine out of 10 new-car loans are now for longer than four years; some are as long as nine years. Longer loan terms lower your payments, which make them seem more affordable, and the lender wins because you end up paying a lot more interest. But you stay in debt longer, pay a lot more for your cars and often remain "underwater" -- owing more than the car is worth -- for most of the time you're paying it off.
Borrowing $25,000 at 5.75%:
| Loan term | Payment | Total paid |
|---|---|---|
3 years | $758 | $27,288 |
4 years | $584 | $28,032 |
5 years | $480 | $28,800 |
6 years | $411 | $29,592 |
7 years | $362 | $30,427 |
- Not insisting on down payments. Allowing you to finance all or almost all of your purchase means lenders can charge higher interest rates. It also ensures you're underwater on the loan from the minute you drive off the lot, thanks to depreciation (a car's value drops 10% or more as soon as it's no longer "new"). You don't even have to pay off your old loan; in one out of five purchases, debt from the previous vehicle is rolled into the new loan. The typical amount of negative equity is around $3,700, Edmunds.com says.
It used to be worse. At the easy-money peak, 30% of loans included debt from a prior vehicle. Even after the rate drifted down to just more than 20% in 2008, the average amount of negative equity swelled to about $4,500.
There was a brief moment last summer when it seemed the tide was turning against underwater loans. As credit dried up, auto lenders got a lot pickier about who got money; by August 2009, only 8% of sales involved negative-equity loans.
But lender reticence quickly vanished as car sales plunged. By September, we were back to 19% of sales including debt from a past loan.
Continued: In the end, you'll pay . . . and pay