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Mellody: In general, people should be very wary of these long-term loans. The biggest risk is that when you finance over a longer period, you are adding more interest to the loan, and more time for the car to depreciate. Vehicles currently lose about 13 percent of their value annually, so if your loan is large and stretched over a long period, it is easy to get to a point where you owe more than the car is worth.

To stay in a positive equity position you need to ensure their principal balance is always in line with the vehicle’s value. Used cars are especially risky. Think about it – say you buy a car that someone traded in after a lease. That means the car is already a few years old, and has lost a significant percentage of its value.

If you take out a 6-year loan on this car, you are still going to be making payments on a 10 year old car – one that is ultimately more likely to need costly repairs – and you are going to have negative equity on it. Then, if you trade it in, you could be in a position where you get into a cycle of adding that previous negative equity to your next auto loan. So there is a lot of risk with longer financing periods, Tom.

Tom: What should we keep in mind if we are buying a car?

Mellody: The biggest thing you need to keep in mind is that you should not buy a car unless you can afford it. And when I say afford it, I mean pay it off in under 5 years. The other thing you need to remember is to avoid getting caught in an underwater equity position. Whether it is long financing, or using a subprime loan, do not get into a situation where the amount you owe is more than the value of your vehicle. If you keep these two things at the front of your mind, you will avoid a lot of trouble.

Tom: Thanks the advice, Mellody! Have a great week.

Mellody: Thanks, Tom!

Mellody is President of Ariel Investments, a Chicago-based money management firm that serves individual investors and retirement plans through its no-load mutual funds and separate accounts. Additionally, she is a regular financial contributor and analyst for CBS news and CBS.com.

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Money Mondays: Why Long Term Car Notes Are A Bad Idea  was originally published on blackamericaweb.com

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