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What to know about auto loan debt

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If you are in the market for a new car, you may be torn between getting a loan and paying cash. While getting a loan could mean driving off the lot in the car of your dreams, you will be stuck making payments for some time. However, using cash to buy a car won’t help improve your credit, and you could wipe out your savings or be forced to settle for an unreliable vehicle.

When an auto loan is a bad idea

Auto loans are relatively easy to get if you have decent credit, a reasonable debt load and a reliable source of income to make monthly payments. However, they’re not always a good idea when looking to buy a car.

You can’t afford the car

A high sticker price doesn’t seem as unappealing when you know you can pay for it over time. But that doesn’t mean you can afford the car, even if the monthly payment fits into your budget. The most recent numbers from Experian show that average monthly payments sit at $667 for new cars and $515 for used cars. Paying in cash can keep a huge chunk of money in your wallet.

“When you pay for the car in cash, the car is yours when you drive off the lot,” says Matt Degan, editor at Kelley Blue Book. “You don’t need to take out a loan or line anything up with a bank, and you won’t have interest payments. The price is the price.”

Also, consider the cost of owning the vehicle, including gas, insurance, registration renewals, maintenance and repairs. Over time, they could add up to several hundred or thousands of dollars. Both Kelley Blue Book and Edmunds have cost-to-own estimates you can use to determine if a car is a good financial move.

The interest rate is too high

Auto loans with favorable financing terms are generally reserved for borrowers with good credit — typically scores 670 or higher. A low credit score doesn’t mean you won’t get approved, but you will likely get a higher interest rate. Near prime borrowers — those with average credit — can expect new car rates around 6.57 percent and used car rates around 10.33 percent, according to data from Experian.

But while the average interest rates have decreased since last year, the federal funds rate has increased recently. This means auto loan interest rates may climb higher in the coming months, making loans less affordable.

To illustrate, assume you have good credit and qualify for a $25,000, 36-month auto loan with an interest rate of 3.99 percent. You will make monthly payments of $738 and pay $1,568 in interest over the loan term. But if your credit score is low and the best rate you can find is 8.99 percent, the monthly payment will increase to $795, and you’ll pay a total of $3,616 in interest.

It could make more sense to pay cash for the vehicle in this case. Or, if you can’t afford the purchase price, find a more affordable car that works for your budget.

You could be stuck with a long term

Most car loans come with loan terms between 36 and 84 months. Some borrowers opt for an extended repayment period to make monthly payments more affordable. But here’s the catch: The lender will have more time to collect interest from you.

Using the examples from above, assume you extend the loan terms to 72 months. With a 3.99 percent interest rate on a $25,000 auto loan, you’ll pay $3,153 in interest. This amount increases to $7,437 if you get an interest rate of 8.99 percent.

If you do opt for an auto loan, go for the shortest loan term you can reasonably afford each month. But if you have the savings to buy with cash, you can avoid paying thousands in interest to a lender — and stay out of the years-long process of paying down a loan.

When to get an auto loan

Even if you can afford to pay cash for the car, it may not be a smart financial move. You can improve your credit score and keep your savings intact with an auto loan, especially if you avoid borrowing more than you need.

You want to build more credit

Auto loans generally come with extended payment periods. Each on-time payment will improve your payment history — which accounts for 35 percent of your credit score. And even when your loan is paid off, it will stay on your credit report for seven years. This means an auto loan will benefit your credit score for a long time — while paying cash won’t.

You are planning to use your cash reserves to buy the car

Depleting your savings is never a good idea when it’s not a true emergency, even if it’s to circumvent making monthly car payments. You are better off making a hefty down payment and keeping the rest of your cash on hand in case you are hit with an unexpected expense or major financial emergency.

There is a deal on financing

If you have your eye on a new car, pay attention to manufacturer and dealer incentives. “Dealers sometimes offer really good financing incentives. That could be cash-back or zero-percent financing. If you get zero-percent financing for three years and pay your loan off in that time, you’ll get the car without paying interest. You can also take that money and put it somewhere else to earn more money which can work in your favor,” says Deegan.

You can shop for your auto loan

There is no shortage of places to get an auto loan. They are readily available through traditional banks, credit unions and online lenders. You can also get financing from the dealership, but it’s often not the best option.

Instead, get prequalified for an auto loan through your bank, credit union or an online lender. The process is relatively quick, and some lenders let you view financing quotes without affecting your credit score. Get several quotes before you formally apply with a lender.

If you’d prefer to get financing through the dealer, ask them to match the best rate quote you have. Some will even agree to beat the rate or offer other deals to earn your business.

Watch out for prepayment penalties

Maybe you don’t have enough cash to buy a car but want to get a loan and pay it off early when you have the money. This idea is viable if the lender doesn’t charge prepayment penalties. But it could backfire if that is not the case.

Prepayment penalties can make it impossible to reduce the principal balance if you make extra payments towards your loan since the lender may apply it to payment due the following month. You could also face challenges if you decide to refinance your loan and find that it’s not worth the cost just to break even or lose money in the end.

Carefully review loan agreements for prepayment penalties before signing on the dotted line. You can also ask your lender if there are disclosures related to these costs that you don’t quite understand.

The bottom line

You can make payments over time and build credit with a car loan — paying cash doesn’t afford you this luxury. Still, paying cash alleviates the burden of monthly car payments for years to come, but isn’t without risk. Ultimately, weigh the benefits and drawbacks of each to decide what’s best for your financial situation.

Written by
Allison Martin
Allison Martin's work began over 10 years ago as a digital content strategist, and she’s since been published in several leading financial outlets, including The Wall Street Journal, MSN Money, MoneyTalksNews, Investopedia, Experian and Credit.com.
Edited by
Auto loans editor