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How to avoid car loan debt
Learn what you can do to avoid taking on too much car loan debt when you purchase a new vehicle.
One of the best ways to set yourself up for financial success in the future is to avoid taking on a significant amount of debt. Unfortunately, snagging your dream vehicle can throw a wrench into your saving plans in the long term by forcing you to take on car loan debt.
This is why it’s important to think ahead and take certain steps to minimize the amount of money you have to spend on a car loan. Use this guide to find out how you can avoid taking on more car loan debt than anticipated when you purchase a new vehicle.
What is car loan debt?
Car loan debt is any money that you still owe on your vehicle before it’s paid off in full. This debt can come in the form of either positive or negative equity. Having positive equity in your vehicle means you owe less than what your car is worth. Negative equity means your vehicle is worth less than the amount you owe.
The determining factor in whether you end up with negative equity usually boils down to the length of your term. Terms that last over five years on a new vehicle will typically come with lower payments, but you’ll end up paying much more in interest. It will also take you longer to pay off your vehicle, which could leave you at higher risk of losing money on your purchase over time.
This is why you should aim to avoid long-term car loans wherever possible to make sure that you don’t end up paying more than you have to.
Positive vs negative equity car loan debt
It’s important to keep in mind that you want to take on the least amount of negative equity debt as possible. You’ll usually have this type of debt for the first three years of your loan – until you’ve paid off enough of your loan to cover the cost of depreciation. At that point, you’ll typically be able to sell your vehicle for more than what you owe (earning you a net profit).
That said, you’ll usually sit in a place of negative equity for much longer if you take out a long-term loan. You’ll also be at risk of sliding back into the red on the tail end of your loan since it will depreciate more every year even though you’re still stuck with the same repayments.
How does car loan debt work?
Car loans are typically secured against the vehicle you want to purchase. This means that your car will serve as collateral for your loan and can be repossessed if you default on your payments. Your loan will typically need to be paid off in fixed instalments – whether weekly, bi-weekly or monthly. Your lender will usually own the vehicle until you make your final payment.
Interest rates for car loans most commonly range between 5% and 30%, depending on your credit score. That said, you may pay higher or lower rates based on which lender you choose. The main rule of thumb when you choose the best financing for you is to find the lowest interest rate possible for the shortest term that you can afford.
How to avoid taking on too much car loan debt
While a small car loan can be a reasonable expense, you’ll want to avoid taking on more car loan debt than you can afford.
- Avoid spending more than you can afford. Figure out how much you can reasonably afford to pay with your current income and debt load. Then make a budget and stick to it for the duration of your loan.
- Factor other costs of car ownership into your budget. Be sure to incorporate the other costs of car ownership into your budget before you decide how much you can spend. These include car insurance, routine maintenance and emergency car repairs.
- Avoid loan terms that exceed five years. Avoid signing up for a loan that requires you to make payments beyond five years. It may seem much more affordable in the short term, but it will cost you a lot more than what the car is worth in the long run.
- Do market research. Look into what the average market prices are for the vehicle you’re interested in. Make sure all of your specs line up and bring this information with you to the dealership to make sure you don’t end up spending more than you should.
- Compare your financing options. Before you sign up for a car loan, you should look at a number of different financing options. Look for the best interest rates for your loan and explore options from various providers, including banks, dealerships and online lenders.
- Consider a less expensive vehicle. If the vehicle you want is out of your price range, it may be time to look for something more affordable. Find out if another car could meet your needs and then trade that in for your dream vehicle at a later date.
- Buy a used vehicle and pay it off with savings. Choose to forego financing altogether by paying off a used vehicle with savings. This will help you save money on interest payments and free up room in your budget to save for future vehicles.
How to pay your loan off faster
Once you’ve taken out a car loan, your main focus should be on paying it off as quickly as possible. This will help you save money on interest and pay less overall for your new vehicle.
- Make a sizeable down payment. One of the best ways to bring down the cost of your loan is to make a down payment. This should be worth at least 20% of the total cost of your vehicle (for example, at least $5,000 saved up on a $25,000 loan).
- Make lump-sum payments. When you get a better idea of how much you can afford each month, you should put any extra money you have in your budget onto your car loan. Just be aware that your loan will need to allow for early repayment for this to work.
- Stay up to date on loan payments. Avoid missing loan payments whenever possible. This will make sure you don’t get charged late fees, you’ll pay your loan off on time and your vehicle will never be at risk of being repossessed.
- Refinance your loan. Consider refinancing your loan at a lower interest rate once you’ve paid off a good chunk of it. This can be a particularly good strategy if your credit score has gone up in the time that you’ve been making repayments.
Benefits of car loan debt
There are a few benefits of taking on car loan debt:
- Buy now, pay later. The main benefit of taking on car loan debt is that you won’t have to put a huge sum of money down all at once.
- Benefit from a more expensive vehicle. You’ll usually be able to afford a more expensive car than you would if you paid with your savings all at once.
- Sell your vehicle for a profit once your loan is paid off. You may be able to recoup some of the money you paid into your vehicle when you decide to sell.
- You could qualify for very low interest rates. You may be able to qualify for interest rates that are below 5%, depending on the state of your credit.
What to watch out for with car loan debt
There are also several drawbacks that come with car loan debt that you should be mindful of:
- Terms for repayment last many years. You may end up in a cycle of negative equity if you take a longer loan term (especially if your interest rates are high).
- Vehicle will likely depreciate quickly. You could end up losing thousands of dollars on your car as soon as you drive it off the lot.
- Interest rates could cost you thousands of dollars. Depending on your credit score, your interest rate may add thousands of dollars to the overall price of your vehicle.
- There’s a risk you could default on payments. You risk having your vehicle repossessed if you can’t make your payments on it for some reason.
Compare car loan options
Bottom line on car loan debt
Taking on a significant amount of car loan debt is never a good idea. That said, there are certain situations where it might make more sense to purchase a car through financing rather than buying it outright. Find out more about how you can avoid taking on too much car loan debt and compare providers today to find the best deal on your next car loan.
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