How to avoid drowning in car debt
With the cost of car ownership increasing, more and more car buyers are looking for a way to lower their monthly payments. Many are doing it by taking out loans that allow them to pay off their car over six or seven years instead of the usual three to five years. According to a recent Kelley Blue Book study, six out of 10 new-car shoppers are now opting for longer-term loans.
These loans can lower your payments significantly, however, they carry their own set of risks:
- They may carry a higher interest rate than a shorter-term loan.
- While you pay less money each month, more of each payment consists of interest.
- Since you’re making payments for a longer period, you’ll pay significantly more interest over the life of the loan. For example, with a simple 72-month loan of $20,000 at 6.75 percent, you’d pay a total of $4,378 interest, compared with $2,545 for a 48-month loan at 6 percent.
- While you’re paying more interest each month, you’re also paying back less of the loan principal. This increases the chance that your loan will become “upside down” -- meaning you could end up owing more on the vehicle than it’s worth.
It’s common to owe more than a car is worth in the first two years of a car loan, since the value of a new car drops quickly during that period. But with a long-term loan, you can stay upside down for a long time, as the car’s value declines faster than your equity increases. And you could end up rolling that unpaid amount into the financing for your next car, increasing your chances of getting upside down again.
So, before you take out a longer-term loan, consider the following ways to lower your monthly car payments without raising your long-term costs.
Get pre-qualified: It’s a good idea to get pre-qualified for an auto loan before going to an auto dealer. You may get a better interest rate and lower monthly payments than those offered by the dealer.
Consider a home equity loan: A home equity loan may allow you to borrow money at a lower interest rate than a standard auto loan and, since the loan is secured by your home, the interest may be tax-deductible (consult with your tax advisor).
Check the numbers: Be sure to find out the true long-term cost of the loan before you commit yourself. First, check the annual percentage rate (APR). That’s the interest rate plus all lender fees and charges, and it reflects the true rate you’ll pay. Next, ask the lender for the total cost -- the sum of all the monthly payments you’ll make during the life of the loan, plus all fees and charges. Compare this with the amount you’d pay on a shorter-term loan.
Read the fine print: As with any car loan, be sure to check all the fees and conditions on the purchase. Are there large financing fees, or a requirement for credit insurance? Most importantly, are there penalties for prepaying the principal during the life of the loan that could prevent you from refinancing or increasing your payments to boost your equity?
Increase your down payment: Making a small down payment -- say, only 5 percent -- increases the cost of a longer-term loan. Cutting back other expenses to boost your down payment to 20 percent or more can save you a lot of money, and may allow you to take out a shorter-term loan.
Buy what you can afford: If you’re tempted to take out a longer-term loan, it could be because you can’t really afford the car you’re buying. You’d be far better off financially to buy a more modest vehicle you can pay off in five years or less.
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