Five mistakes that can lead to a bad car loan
As if we need more bad news about car buying, an analysis by Consumer Reports shows that many Americans are drastically overpaying for their car loans. And we can’t place all the blame on the pandemic or supply chain problems.
In one case, Consumer Reports found that a Maryland resident with “sterling credit” who bought a new 2018 Toyota Camry two years ago will end up paying $59,000 by the end of the loan. The reason: Their interest rate was bumped up to 19% when they actually qualified for a rate of 4.5%.
The Consumer Reports study, which looked at 858,000 car loans, concluded that bad car loans, the rising cost of cars and other factors have pushed the average monthly car payment to about $600 — an increase of almost 25% over the past 10 years.
With a little education and free online tools, such as a car payment calculator, you can set up a loan that works for your budget and avoid some common car loan pitfalls.
1. Extending the loan’s term
The term is how many months it takes to pay off the loan. The longer the term, the lower the monthly payments. However, the longer you take to pay off a loan, the more interest you will pay.
For example, if a person with a credit score of about 600 buys a $30,000 car and finances it for 60 months at the rate of 6.61%, they’ll pay $5,311 in interest. But if that loan is extended to 80 months, they’ll pay $7,175 in interest. That’s an extra $1,864 up in smoke.
2. Not shopping for your loan
Before you shop for a car, you really should shop for a loan. Start by checking your credit and resolving any issues you discover. Then, apply for a preapproved car loan from a credit union or online lender. By doing this ahead of time, you can choose the down payment and loan term to fit your budget.
Getting preapproval also simplifies the negotiation process because it gets you focused on the out-the-door price. You can always take the dealer’s financing if the interest rate is lower. But your preapproved loan will serve as a bargaining chip to get its best rate.
3. Being ‘upside-down’ on a car loan
You’re upside-down on a car loan when you owe more than the car is worth. If you experience an unexpected life change — a divorce, death or sickness in the family — and you have to sell the car, you’ll have to pay off the loan, plus the negative equity.
On the other hand, if you have equity in your car, you can use that as a down payment on your next car. Or just sell it, pay off the loan and pocket the difference.
4. Rolling negative equity into the new loan
If someone is upside-down on a car loan, but they just have to buy that new car, the dealer will be happy to roll the negative equity into the next loan. In that way, a person who is $10,000 upside-down on a car loan can buy a $30,000 car and wind up with a $40,000 loan.
There’s no good reason to roll negative equity into a new loan. Doing so can lead to a spiral of debt as you try to keep up with the payments. Instead, keep driving your current car and try to make extra payments until you’re right-side up.
5. Buying extras
Sometimes, that car you agreed to buy has dealer-installed options that aren’t listed on the sticker. If that’s not enough, the finance manager might give you the hard sell on an extended warranty, a wheel and tire warranty or a prepaid maintenance plan.
All of these extras go into your balance on the sales contract and result in a much higher loan to pay off. The best strategy is to flush out those extras early in the negotiation process. I like to ask for an out-the-door price with a breakdown of all the costs and fees.
Here are several ways to keep control of your car loan:
Use a car loan payment calculator to estimate your monthly payment. Try using different terms and down payment amounts to see what works best for your budget.
Be realistic about what monthly payment you can afford, and shop for a loan that meets that criterion.
Getting preapproved for a car loan is perhaps the single best way to keep control of your car-buying transaction.
Carry as little debt as possible by saving for a down payment of at least 20% of the purchase price.
Reed writes about the auto industry and finance for NerdWallet.com. His Twitter handle is @AutoReed.