Car prices are increasing—here's how that can hurt Americans
Sure, that new car smell is great. But is the prospect of owning a new vehicle worth going into debt for years to come?
Over the past few years, car prices have been rapidly increasing. While that can be a good sign for the economy, it means consumers will have a harder time affording new vehicles. And because 64% of U.S. adults drive daily, as prices go up, many who rely on their cars for transportation could be forced to take out long-term auto loans in order to afford one.
Why are car prices going up?
In May of 2019, the average price of a new car purchased in the U.S. climbed to $36,718, with interest rates hovering around 6%, according to automotive information site Edmunds. That's up from $35,742 in 2018, which was already a 2% increase from 2017, according to Kelley Blue Book.
This increase in automobile prices is due to a number of factors, including rising interest rates and higher average transaction prices, Edmunds reports.
In 2018, interest rates began to increase, and by April 2019, the annual percentage rate (APR) on new vehicles averaged around 6.4% — marking a new record since 2009, according to Edmunds. Although interest rates fell to 5.7% as of September, they remain inflated, and the cost of purchasing a new car is "still a lot higher than it was a few years ago."
In September 2014, by comparison, the average APR on a new car was just 4.2%.
Additionally, shifts in consumer preferences and industry trends have led, in part, to higher average transaction prices. That's because there's a trend toward bigger cars, rather than compact ones, with more advanced features. Think built-in navigation, Bluetooth capabilities, high-tech safety features and more, which "certainly helps to move prices upward," Ivan Drury, a senior manager of industry analysis at Edmunds, tells CNBC Make It.
Buyers are also choosing to splurge more on high trim level vehicles than they used to, Drury says. A vehicle's trim level, also sometimes referred to as a "trim package," is determined by the kinds of features it comes with, including any premium-grade finishes, high-tech features and performance upgrades.
Back in 2008, the average base manufacturer suggested retail price (MSRP) for a car was $23,900 with consumers choosing to add around $6,500 in options and trim levels, bringing the car's overall price to $30,400. In 2019, by comparison, the average base MSRP rose to $29,000 with consumers paying around $10,000 for trim level add-ons, which brings the total price to $39,000, Drury explains.
"We attribute this to the increasing amount of options that are technology-based and can add up quickly if someone wants the latest and greatest," Drury says.
Why are rising car prices a problem?
In the last 40 years, wages for American workers have hardly risen, according to the Pew Research Center. But in the past few years, automobile prices and interest rates have increased rapidly. This discrepancy has made it difficult for many Americans to afford cars, the Wall Street Journal reports.
As a result, many U.S. adults have taken out auto loans with longer terms, which means they're often left in debt for years and end up paying more in interest over time. In 2018, the most common term length for an auto loan sat around 72 months, or six years, with 84-month loans at a close second, according to Edmunds. By the first half of 2019, more than a third of auto loans for new vehicles had terms of longer than six years, according to credit reporting firm Experian.
"For many Americans, the availability of loans with longer terms has created an illusion of affordability," the Journal reports.
That's because the longer the loan, the more interest you to the lender, in addition to the principal. Plus, longer term loans tend to have higher interest rates, Edmunds reports, which costs you more over the life of the loan, even if the monthly payments are lower.
"Try not to fall into the trap of extending the life of a loan to keep your monthly payments lower," says Mike Quincy, a car-buying expert with Consumer Reports. "A 72- or 84-month loan will increase the amount of interest you wind up paying. That's why you should try to put as large a down payment as you can in the beginning."
Additionally, when buyers funnel money into a new car, they're paying for a depreciating asset. "If you are thinking about purchasing a new car with a loan, you should always remember that, on average, cars drop more than 20% [in value] as soon as you drive off the dealership lot," Ryan Marshall, a New Jersey-based certified financial planner, tells CNBC Make It. After 20 years, your car's value will have dipped by close to 90%, Marshall says.
That means that no matter how much money consumers put into a car, they'll likely earn just a fraction of it back if they decide to sell the vehicle and buy a new one.
Buyers should also take into account whether they are realistically going to keep their automobile for longer than the length of the loan. "Loans of five or six years are realistic term lengths, but only for those consumers that are committed to keeping their vehicle for that length of time or longer," Drury says.
In the U.S., the average length of new vehicle ownership stands at 79.3 months, or nearly seven years, according to data from research company IHS Markit. The same holds true for Marshall's clients, who he says keep their cars for an average of seven years. As a result, he typically recommends taking shorter loans.
"If you can't pay it off in three or four years, you probably can't afford the car to begin with," Marshall says. "By the time seven years is up, you are probably starting to look for a replacement car and will need to start this process all over again."
How should you approach taking a car loan?
Before buying a vehicle, you should figure out "how much car" you can realistically afford. While some experts advocate for the "15% strategy," meaning 15% of your take-home pay would be the maximum amount you can put toward your monthly car payments, it's smarter to take a look at your past loans as a gauge for future ones, Drury says.
"Ask yourself: Was it difficult to pay off each month or did I ever fall behind?" Drury says.
If you've never had an auto loan, try putting away the same amount of money you'd expect to spend on a car loan payment for three to six months. If the exercise causes you to go over budget, you can then "adjust accordingly and perhaps shift the saved money toward a down payment," Drury says.
Another useful tool is to use an auto loan calculator, such as the one provided by Edmunds. By entering your zip code (to see your local rates and pricing), details about the car you're looking to buy, any applicable trade-in or down payment information, potential financing options and your credit score, you'll get a monthly loan payment estimate, which can help you to determine whether you can afford the car in question and what your monthly payments would look like.
Don't miss: Jay Leno: Don't lease a car. Buy.
Like this story? Subscribe to CNBC Make It on YouTube!