Getting a car loan isn't great for your finances because you have to pay interest on an asset that's depreciating in value from the moment you drive it off the lot. Expensive car payments can also make accomplishing other goals harder.
Still, despite the fact car loans have downsides, most people get them anyway for a very simple reason: they need cars and can't afford to buy them with cash.
If you're shopping for a car loan, you can do so responsibly -- you just need to be smart about where and how you secure financing. Here are three steps to take to ensure you're a responsible borrower when you buy a car.
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1. Shop for financing outside the dealership
Far too many borrowers get financing through their car dealer without giving a second thought to whether this is really the best deal. Because dealers often advertise special promotional financing, it's very tempting to just take out a loan and hope for the best.
In some cases, you'll get a pretty good deal by borrowing through the dealer -- especially if you have good credit. But, dealers also make a profit on financing and the rates and terms they offer aren't always the best.
Instead of defaulting to dealer financing, price out the car you want to buy and explore all your loan options through banks, credit unions, and online lenders. Compare interest, the length of the loan, loan origination fees, and any prepayment penalties for repaying early. If you can get a better deal outside the dealership, take it.
You may also decide to get creative with vehicle financing. If you're going to pay off the car within around a year of buying it, you may be able to use a credit card to pay for at least part of it. You could use a balance transfer and get a check from your credit card -- which usually comes with around a 3% transaction fee -- and essentially do a cash deal with the car dealer using this money. You could also pay for part of the car on a card with a 0% introductory rate on purchases, but dealers will limit how much of the car you can charge.
2. Borrow the minimum
If you have to borrow to buy a car, you shouldn't be buying a very expensive vehicle. Unfortunately, Experian's recent report on the state of auto financing revealed the average new car borrower financed $31,445 in the first quarter of 2018 -- a new record and an amount that slightly exceeds per capita incomes. That means people are borrowing more to buy a car than they make in a year!
With record high balances and average interest rates up to 5.17% -- an increase of about a third of a percentage point compared with a year ago -- borrowers are paying more than ever for new vehicles with monthly payments reaching a record-high of $523.
This is way too much money so just don't do it. If you instead borrowed $15,000 to buy a used car, a loan at 5.6% repaid over four years would give you a monthly payment of $350 and leave you with $173 extra per month to invest.
If you put $173 monthly into a retirement account earning 8% from age 30 to age 65, you'd end up with almost $400,000. Would you rather have a nicer car or a 401(k) worth more than double the average pre-retiree's savings?
3. Don't stretch out your loan term
Experian also revealed another troubling statistic: Borrowers are taking out loans that last longer than ever.
Average loan lengths for new vehicles reached 69 months in the first quarter of 2018, but 72-month loans still remain the most popular term. Troublingly, almost one-quarter of borrowers took loans lasting between 85 and 96 months. In 2008, only 10% of borrowers took loans they'd be repaying for so long.
If you take eight years to repay your car, or even 5.7 years, chances are good that you'll be itching for a new car as soon as it's paid off. You may never get any time when you don't have car payments and could devote your income to building wealth.
Furthermore, stretching out your loan over a long time means you're going to end up paying a lot more interest. If you took the average $31,445 car loan at 5.6% and financed the car over different periods of time, here's what the math looks like:
|
Loan Term (In Months) |
Monthly Payments |
Total Loan Cost |
|---|---|---|
|
48 |
$733 |
$35,171 |
|
60 |
$602 |
$36,125 |
|
69 |
$534 |
$36,852 |
|
72 |
$515 |
$37,096 |
|
84 |
$453 |
$38,082 |
|
96 |
$407 |
$39,085 |
Chart and calculations by author.
While the $407 monthly payment may seem much more affordable than the $733 payment, you'd pay almost $4,000 more for the same car!
If $733 seems like too high a payment, that's where borrowing just $15,000 helps. Consider the math on a $15,000 car loan over the same time period at the same interest rate.
|
Loan Term (In Months) |
Monthly Payments |
Total Loan Cost |
|
24 |
$662 |
$15,891 |
|
36 |
$454 |
$16,330 |
|
48 |
$350 |
$16,777 |
|
60 |
$287 |
$17,233 |
Chart and calculations by author.
As you can see, shorter loan terms are much more affordable. You could pay off the car sooner, save your "car payments" to pay cash for your next vehicle, and still have money left over.
Be smart about your car loan
Driving a safe and reliable car is important, but that doesn't mean you should borrow a fortune for one. Finance your car with the lender offering the best deal, buy the cheapest car you're comfortable with, and finance a car for the shortest term you can afford, and you'll be in much better shape for the long-term.
