Using a Personal Loan to Pay Off Your Car
Whether you’re buying a new car right off the lot or opting for a used vehicle, the vast majority of car buyers finance the purchase. Over 86% of new vehicles purchased in the U.S. during the second quarter of 2018 were indeed financed, according to Statista. But auto prices and interest rates are both on the rise; a potentially expensive combination that could put you in over your head.
The average loan amount for a new car is over $31,400, according to Experian. The number for a used vehicle loan is $19,536 — a record high. Monthly payments are also climbing steadily. Most folks shell out $523 every month for the luxury of having a new car.
More and more borrowers are offsetting the cost by opting for longer loan terms. Stretching out the repayment timeline effectively reduces your monthly payment. The Consumer Financial Protection Bureau reports that 42% of auto loans made between 2016 and 2017 had payback terms of six years or more—up from 26% in 2009. The problem is that a longer repayment period also means paying more in interest over the life of the loan.
One other major snag: That same CFPB report found that loan default rates are twice as high among those who choose a longer term. Even if you keep your loan in good standing, being upside down on your car loan (in other words, owing more than the car is actually worth) is never an ideal situation.
But it’s more than possible to get yourself back on solid financial ground. Enter the personal loan — a viable way to get out from under an upside down car loan.
How to tell whether or not your car loan is upside down
Cars are unique assets in that they begin depreciating in value almost instantly. In fact, a new car loses about 10% of its value the moment it’s driven off the lot, according to Carfax. From there, the average vehicle’s value will continue declining to the tune of 15% to 25% every year.
Being “underwater” or “upside down” on your car loan simply means that the amount you owe is greater than the actual value of the car. Determining whether or not this describes your situation requires crunching some numbers. Kelley Blue Book can help you estimate how much your car is worth based on its year, model, mileage, color, style and general condition.
Once you have a general idea of what your car is worth, compare that number with your current loan balance. You can find this by logging into your online account with your lender. If you owe $11,000 and your car is worth $6,000, then you’re $5,000 underwater. This is just another way of saying that you have negative equity.
Can you use a personal loan to pay off your car?
A personal loan is a new loan you can use any way you wish, from consolidating debt to funding a big purchase, to seeing you through an unexpected financial emergency. You’ll receive a lump sum, typically deposited right into your bank account, that you can then use to pay off your upside down auto loan. After that, you’ll only be responsible for repaying the personal loan.
Unlike credit cards, which are revolving lines of credit that you can charge up and pay off as you go, personal loans are installment loans. They come with a fixed interest rate, repayment timeline and monthly payment, so you know exactly what you’re getting into from the get-go. Interest rates vary depending on the borrower’s credit score, but those with good credit (a score of 640 to 699) could potentially lock in a rate as low as 3.49%. The average interest rate on a loan for a new vehicle is 5.17%, according to the Experian report mentioned earlier.
The pros and cons of using a personal loan to pay off your car
Toying with the idea of using a personal loan to pay off your car loan? Here are some pros and cons to consider.
- You could land a lower interest rate. Interest rates have everything to do with your credit score. Simply put, the higher your score, the better your rate.According to ValuePenguin data, the average interest rate for a 5-year auto loan on a new car is about 3.6% for those with excellent credit. Folks with average to good credit can expect a rate that falls somewhere between 4.95% and 9.72%, while those with poor credit could be stuck with a rate as high as 15.24%.
Check in on your auto loan to see what you’re currently paying in interest. If you qualify for a lower-interest personal loan, you’ll likely end up paying less over the long haul.
- You may be able to pay your debt off sooner. This comes back to the term you choose. If you use a 3-year personal loan to pay off a 5-year auto loan, you’ll ultimately get yourself debt-free faster. Just keep in mind that a shorter term translates to a higher monthly payment, but if your budget allows, you’ll end up keeping more cash in your pocket in the long run.
- It protects you from losing your car. If you default on a car loan, the bank is within its rights to come and repossess your car. But if you get a personal loan and repay your auto loan, “the car isn’t collateral anymore,” said Scott Snider, a Jacksonville-based CFP. “If you’re about to default and you’re stuck between a rock and a hard place, a personal loan could be a last resort that saves you from losing your car.”
- It could reduce your monthly payment. If you’re financially strapped, paying off your car with a longer-term personal loan could reduce your monthly payment and provide some much-needed breathing room. Just don’t forget to look at the big picture. A longer repayment period means paying more in interest when all is said and done.If you do go with a personal loan that doesn’t have any prepayment penalties, it could serve as a Band-Aid that sees you through a rough financial time. Once you’re back on your feet, you could always accelerate your personal loan payments and get debt-free ahead of schedule.
- It isn’t necessarily less expensive: There are a lot moving parts to consider here. Depending on your credit and repayment terms, you may only qualify for a personal loan that has a higher interest rate than your existing car loan. If this is the case, paying off the car loan may feel like progress, but you won’t really be moving the needle on your debt.
- You’re trading debt for debt. Using a personal loan to pay off an upside-down car only makes sense if it’s part of a bigger financial strategy. Your budget should be able to comfortably absorb the new loan so that you’re still able to meet your other financial obligations while making progress on your money goals. Blindly shuffling your debt around with no plan in place won’t actually serve you, especially if you only qualify for higher-interest personal loans.
“It’s kind of like robbing Peter to pay Paul,” says Snider. “You’re delaying the inevitable and making it more expensive for yourself if you’re just looking for a quick shortcut.”
Finding a personal loan to pay off your car
Like anything else, it pays to shop around. Begin by comparing lenders online to see who’s offering you your best rates and terms. And be sure to check your credit score (you can do that for free with this handy tool) and credit report to make sure it’s accurate and contains no errors. You can view your credit report free of charge at AnnualCreditReport.com.
Before pulling the trigger on a personal loan, think about which term makes the most sense for your financial situation. Would you rather have a shorter term that allows you to pay the loan off faster, even if it comes with a higher monthly payment? Or are you more comfortable stretching out the repayment term and paying more interest over the long haul if it provides lower payments?
Once you’ve clarified these things and have narrowed down a few offers, it’s wise to read the fine print. Are there any prepayment penalties? And does the lender charge an origination fee (aka a fee for taking out the loan itself)? These details impact the cost of the loan.
3 other ways to deal with your upside-down car
Sell your car
If you’re in need of a new car anyway, Snider says many auto companies will let you trade the old car in, then fold any negative equity into your new loan. This is a viable option for those who need a reliable car and are OK with taking on new debt.
Things get a little tricky if you’re looking to sell the car altogether through a private sale. In order to transfer the title over to a new owner, you have to pay off your original loan first.
Translation: You’ll have to come up with the cash to cover whatever you owe.
“Rarely in private sales do you earn enough to pay off the loan,” Cincinnati-based CFP and CFP Board ambassador Bill Schretter told LendingTree.
If you’re in a financial bind, another option is to go through with a private sale, then take out a personal loan to cover the negative equity. The monthly payment could potentially be more affordable, and once it’s paid off, you’re off the hook entirely.
Refinance your auto loan
Before going through with a personal loan, Snider suggests first exploring your refinancing options. Begin by reading the fine print on your auto loan. Are there any prepayment penalties or policies that won’t allow you to make principal-only payments? If there’s language in there that prevents you from accelerating your payments, you may be stuck with that loan term for the duration.
But if not, refinancing to a new loan with either a lower interest rate or a shorter term could be the answer. A shorter repayment timeline will increase your monthly payment, but you’ll pay less in interest and ultimately eliminate the balance faster.
Keep your car until you owe less than the value
“Very often, people are underwater in their car because they’ve had such high mileage on it,” said Schretter. “I’d say try and reduce the mileage on it, keep it in good shape and wait until you’re not underwater; you need a car.”
In other words, it may be better to reduce wear and tear on the vehicle and give it time for the value to mature. Struggling to keep up with your payments? Take a look at your expenses to pinpoint areas you may be able to curb your overspending. According to Snider, a personal loan should be the option of last resort.
“Most people have two or three areas where they spend more than they probably should. Food, entertainment, groceries — those are areas where some quick cuts can be made,” he said. “You have to make a sacrifice if the car loan itself has become a major pain point.”
Some parting thoughts
The first thing on your to-do list should be ballparking your vehicle’s value and comparing it with your loan balance to figure out if you’re indeed upside down on the car.
Also consider if a personal loan make sense. If you can lock in a lower interest rate or better terms, it’s definitely worth considering. If not, selling your car may be the best way to go, assuming you can come up with the cash to cover any negative equity. Alternatively, you may be able to trade in the car and simply fold that amount into a new auto loan.
It really all depends on your situation and what you’re comfortable with, but the take-home message is that being underwater in a car loan isn’t the end of the road. There are plenty of available options at your fingertips, including a personal loan, to help see you through.