This article is part of our 52 week journey through Bill’s latest book, The Graduate’s Guide to Life and Money. Each week, a full excerpt from his book will be presented from beginning to end. To get your copy of his book, visit www.TheGraduatesGuide.com.
Now, let’s discuss some of your financing options. Clearly, paying cash is the way to go. If you have enough money sitting around to buy your car without taking out a loan, this is the best method. Not only can you be free and clear of any ongoing monthly payments, but also you may be able to negotiate a better deal. After all, the sale will be much easier to the dealer or the individual selling the car if you can walk up to them with a certain amount of money in a certified banker’s check. They don’t have to wait for financing approval and there is less paper work. You’ll also notice that some car companies advertise the choice between low financing rates and cash back (for instance, 0% financing for 60 months or $3,000 cash back). Essentially, you are saving $3,000 in this example just for already having the cash available.
Assuming you are like most people, you don’t have enough money lying around to buy a car. That means you are going to have to borrow money or lease. Have you decided which to do? The answer depends on how long you will keep your car. Basically, if you are the type to trade in your car for a newer model every three years, perhaps leasing is the way to go. Of course, if you plan to lease, maybe you should go back through this book and read a little closer. Otherwise, it makes more sense to buy your next car. By leasing a new car every three years, you essentially never really own anything. You are simply renting the car for three years, and then renting a new one for three years, etc. You will constantly be paying for a car. You will never get to enjoy that brief period of time after you own the car outright, just before it dies.
Your best option, in this case, would be to buy the car. Car loans usually exist as simple loans. You borrow a certain amount and pay a fixed payment every month, based on the interest rate and the length of the loan (three years, four years, five years, etc.). After the length of the loan (i.e. five years) your loan balance will be paid off and you are finally the proud owner of a car. Of course the warranty is usually over at this point, so be prepared to spend money for repairs.
There are three factors to your car loan that affect your payment; the amount borrowed, the interest rate and the length of the loan. The higher the interest rate, the higher your payment. The more you borrow, the higher your payment. The longer your loan, the lower your payment. Wow, it almost sounds like a low interest, low cost loan for as long as possible is the best deal, but it’s not. You definitely want to get the best price you can for the car and get a loan for the least amount of interest, but you do not want to stretch your car payment for longer than you have to.
Sure, a six-year loan has a much smaller monthly payment than a three-year loan, but you will be paying much more for your car. Here is an example. Assume you bought a $10,000 car with nothing down, so your total loan is $10,000. If the bank offers you two loans, both at 8%, but one loan is for three years and the other is for six years. The 6-year loan will have payments of $175 per month, but you will pay $2,623 in interest. The 3-year loan will have payments of $313 per month, but you will only pay $1,281 in interest. The 6-year loan may have had smaller payments, but the car cost you $1,342 more (you paid double the interest to borrow the money).
Another problem to consider with a long-term car loan is being upside-down on your loan. Upside down means you owe more on your car than it is worth. How does this happen? In Chapter 9, on debt and credit, we will discuss that with most loans, you are paying much more money towards interest in the beginning and very little towards the principal. In the example above, if you would have chosen the 6-year loan, after three full years you would have still owed $5,600. The problem is that your car is probably only worth about 80% of that, or $4,800 since your car depreciates so quickly.
What’s wrong with being upside-down? To begin, it is never a good thing to own something that takes away from your net worth. On top of that, what happens if you want to get rid of your car for some reason (too small, new child, new job, etc.)? If you sell your car, you will have to come up with the difference in order to pay off the loan, otherwise the bank, which holds a lien on your car, will not allow you to transfer the title. If you trade the car in, you will have to apply the remaining loan balance towards your new car. In other words, if you still owe $7,000 and you trade the car in for $5,000, the remaining $2,000 will be added on to the loan of your new car. You purchase a new $18,000 car, but your loan will be for $20,000. Now you will start out by being upside down on your next car!
You can see that this leads to a vicious cycle that never gets any better. Another problem with being upside down on a car is if you total it. If you are in an accident that badly damages your car, and your insurance company figures it is cheaper to pay you what the car is worth than to fix it (see insurance, Chapter 11), you may receive less than what you owe. Now you are stuck paying off a car you no longer even own. That’s about as bad as it gets.
I know it is difficult to maintain the balance between getting a reliable car, making your monthly payment, and paying off your car as soon as possible. Nobody said it was going to be easy. Try to get a loan that will allow you to pay off the car within three years, while still having a little left over to pay for the maintenance costs. If you are able to do this with your first car, great, but I don’t expect this out of most people until their next one. The longer your loan, the more you will pay. Is that $15,000 car really worth $18,000? You have to be the one to decide. If you find yourself wavering between two cars of different prices, or thinking about extending your loan, please read Chapter 9; maybe that will help sway you in the right direction.
Next week you will learn how to maintain your car to extend its life and save money.
Bill Pratt is a former credit card executive turned student-advocate. He is the author of Extra Credit: The 7 Things Every College Student Needs to Know About Credit Debt & Ca$h and The Graduate’s Guide to Life and Money. Bill speaks at colleges to educate and entertain students about real-life issues in money, leadership, and success. His goal is to help students succeed personally and financially so they can improve the lives of those around them. You can learn more at www.ExtraCreditBook.comor www.TheGraduatesGuide.com.