Relentless debt: US loans are dragging; root cause multiplies

Consumers who are confronted with soaring asset prices and increasing interest rates have limited choices when it comes to loans, and unfortunately, none of these options are particularly appealing.

If individuals are considering purchasing a new home or car, it may be more advantageous for them to wait.

However, if they are compelled to proceed with the purchase, they are left with two alternatives: either assume a substantial monthly payment or extend the loan term in order to reduce the monthly bill.

This is a course of action that many individuals are currently adopting.

According to data from Edmunds, the proportion of new car loans lasting 73-84 months (over six years) rose from 28.6% in 2018 to 34.4% of the market in 2022.

Some borrowers are even opting for longer loan terms, with less than 1% of new car loans spanning 85 months or more.

Ira Rheingold, the executive director of the National Association of Consumer Advocates, remarked that this trend is a reflection of the financial difficulties faced by individuals in today’s world, particularly concerning transportation affordability and housing.

Dealerships are increasingly offering extended loan terms, surpassing the traditional three to five years, in order to enable more people to purchase vehicles.

Similarly, in the housing market, lengthening mortgage terms has become a necessity to make homeownership a reality for some individuals.

Ultra-long loan terms have also emerged in the housing sector, where homeowners struggling to meet their Federal Housing Administration (FHA) mortgages can now request loan extensions up to 40 years to reduce their monthly obligations.

Even personal loans are experiencing an increase in loan terms.

Data from the LendingTree platform shows that the median term for personal loans closed in May rose to 60 months, up from 57 months in April and 54 months in March.

While extending a loan may not always be unfavourable, it can serve as a stable foundation for building family wealth, especially if the loan has a low fixed interest rate and is associated with an appreciating asset like a 30-year mortgage.

However, it is crucial to exercise caution and avoid extending the life of a loan solely for short-term affordability.

Rheingold advises adhering to one principle regardless of the asset: “Be very wary of extending the life of your loan just to make it affordable in the short-term.”

Financial experts offer several tips to navigate these circumstances. Although a lower monthly payment may seem enticing, opting for a longer-term loan will ultimately result in higher interest costs, often at a higher rate to compensate the lender for the increased risk.

Consequently, such loan offers may appeal to banks but are less advantageous for borrowers.

Financial planner Eric Scruggs of Stoneham, Massachusetts warns buyers to be sceptical of such offers.

To illustrate his point, he provides an example: a $35,000 car financed over five years at 3% interest would amount to a total of $37,734 in payments.

However, if the same car were financed over seven years at 5% interest, the cost would rise to $41,554—an additional $3,820.

If individuals find themselves consistently extending loan terms to afford an asset, it may be an indication that they should consider purchasing a more affordable alternative, as suggested by Brandon Gibson, a financial planner from Dallas.

Extending loans further into the future also exposes borrowers to a longer period of being “underwater,” meaning they owe more on the asset than it is worth.

This situation commonly arises with cars but can also affect homes during periods of declining prices, such as the subprime mortgage crisis from 2007 to 2008.

Erin Witte, the director of consumer protection for the Consumer Federation of America, emphasizes the problems associated with being underwater.

It can make it exceedingly challenging to trade in a mere minute.