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Debt - Auto Loans

By William Sun


Overview


For many, getting their own car for the first time is a huge milestone. With this new car comes a newfound sense of freedom and responsibility to go to whatever place you want - from taking your friends to the beach to exploring old neighborhoods. However, with this privilege comes a significant cost - about $34,852 on average (1). As the price of vehicles continues to climb in America, so does the amount of auto debt. In fact, the total auto loan debt in the US has recently peaked at a whopping $1.43 trillion (2).

Considering this problem, it is imperative that we make the right choices when it comes to buying a car - understanding the different types of loans, how to manage auto debt, and how to pay it off.


Auto Loans


Just like any other loan, an auto loan is money borrowed that needs to be paid back with interest. Usually, they are simple interest loans, paid back over 3-5 years. Simple interest loans are loans where the interest is compounded based on the original amount & you pay the same amount of interest per installment. But how exactly do these auto loans work?


A lender will give a borrower a specified amount of money that needs to be fully repaid in monthly installments with interest (a percentage of the amount loaned paid annually). Then, based on your own financial situation, you could choose different monthly payment plans.


For example, let’s say that you wanted to buy a $30,000 car. After finding the ideal loan for $20,000 of the cost, you find that the interest rate is 5%. If you decide to pay over the course of 5 years, you will pay $377.42 per month with a higher interest amount paid overall. On the other hand, choosing a 3-year payment plan would mean a monthly payment of $599.42 per month with a lower interest amount paid overall.


Thus, generally, longer payment plans mean more flexible monthly payments but with a higher interest amount paid overall while shorter payment plans lead to higher monthly payments, but less money paid back overall. When making a payment plan, it’s important to consider your family’s income, expenditures & other factors to boost your personal finance & follow your budget. Determine how much money you & your family are willing to pay per installment & plan your budget accordingly. Check out these articles on budgeting and personal finance to learn more.


It is also important to note that these auto loans can come from a variety of sources. Apart from loans given directly from car dealerships, which often give higher interest rates, banks and other private lenders (Capital One, Carvana, etc.) also give out auto loans based on one’s credit score and income. Check out this article on credit scores for more information!


Effects of Car Debt and Loans


Unfortunately, loans and debt come hand in hand. And just like any other debt, auto loan debt can lead to severe consequences for borrowers.


Impacted Credit Score- Just like missing any other debt payments, building up auto debt can impact one’s credit score. As your debt accumulates, you miss more monthly payments, and your billing history begins to show more and more holes, your credit score could drop significantly. This lowered score not only decreases your ability to take out loans but also causes lenders to give higher interest rates to you.


Negative Equity Cycle- Due to cars being depreciating (losing value) assets, many borrowers run the risk of running “underwater”- meaning that the value of the car is lower than their auto debt (3). If this happens, car dealers may turn to shortfall financing, where they transfer the difference between the car value and your debt onto your next car purchase. For instance, if your car’s value is $17,000 and your debt is $20,000, a $3,000 trade-in shortfall could be added to your new car-loan balance.


No long-term benefit- Ultimately, the long-term effects of unfair car loans and auto debt poses great risks for the future. Considering whether you may expand your family in the future, move somewhere new, or suddenly boost your income, many people like to jump from car to car over the years. As such, it isn’t logical to take out a significant loan and debt for a single car if you switch cars within the next decade. Moreover, a significant loan risks the negative equity cycle as discussed earlier. Apart from impacting your daily lifestyle and ability to make other large purchases, this resounding debt and payments could seriously affect people’s retirement plans.


What to do


Despite all the damaging consequences of auto loans, there are countless precautions and actions you can take to safely take out auto loans while avoiding debt.


Firstly, there are certain dangers to look out for.


Subprime loans- These are loans given to individuals with lower credit scores, around 580 to 619. With these loans, lenders often charge their borrowers much more money due to having higher delinquency rates (delinquent loans mean that you are behind on payments). Most importantly, the interest rate for the car is much greater than other auto loans. In fact, according to the Columbia Business Law Review, subprime auto loans can have interest rates upward of 29% (4). Furthermore, extra fees, including service contracts or processing fees, can also pose a risk. The potential of the loan being defaulted and the car being repossessed (the lender takes the car away due to missed payments) is much higher for subprime loans.


Extra Fees- With any car loan, there are tons of unfair fees to look for. At the dealership itself, there are countless ways a lender or deal may try to stack on extra payments to the unsuspecting buyer. Various illegitimate fees include advertising fees, loan payment fees, and dealer preparation fees. Even more critical is the state of the car. If the car has received no inspection beforehand, there may be some damage to the car, whether it be a leaked fluid or a cracked windshield. This could lead to extra payments for repairments that could be avoided. On the other hand, some dealerships will even inform you that a part will be replaced long before they actually do.


Various Fraudulent Scams- With any business, scams are a part of the consumer process. When it comes to auto loans, most scams involve trying to confuse the buyer into taking out greater loans for more expensive cars. For example, the yo-yo scam involves dealers that give car loans to those with low credit scores, then contact them weeks later to inform them that the financing didn’t go through. This forces the buyer to choose a different lender with higher interest rates, leading to tremendous extra dollars paid in interest. The more simple 4-square method is where dealers combine the price, down payment, monthly payment, and trade-in value all into one price to confuse the buyer. Overall, you must be extremely careful and scrutinize every step of the car-buying process to avoid scams.


To effectively take care of any auto debt, certain steps can be taken.


Adopting the correct payment plan- If you are stuck in a tough financial situation, transitioning into a long-term payment plan may help you get by with lower monthly payments, allowing you to avoid missing payments and thus, maintain your credit score. In contrast, if you have enough money and want to pay less money overall in the long run, a shorter monthly payment plan will allow you to pay less interest overall. Understanding your assets, income, and DTI ratio will allow you to make an informed choice. A potential resource to help you is this car loan repayment calculator.


Refinance the auto loan- By refinancing your auto loan with another lender, you may be able to secure better terms if you have improved your credit score, getting perks such as lower interest rates and cancellation of any fees. Moreover, through refinancing your auto loan, you could better change your payment plan, getting the benefits mentioned above.


Work with the lender- This process of paying off debt doesn’t have to be a solo job. Working with the lender can allow you to be more flexible in your monthly payments and interest rates. From simply asking your lender to move payment dates to even asking for a payment extension or deferral, talking with the lender opens up opportunities to avoid missing and accumulating payments. When doing so, however, make sure that communication is as open and clear as possible to avoid any unintentional changes. Besides securing your lender's ID and contact information, getting your lender to agree to things in writing secures your desired changes.


Change payment types- Changing the way you pay off debt can also be beneficial. If you have got enough assets or money in the bank, simply paying off the entire loan at once in a full lump sum payment can be helpful, or even paying off a greater part of the payment at once in a partial lump sum payment can help. Other choices, such as making extra or larger payments each month more than required, can contribute towards less interest paid overall and a quicker payment plan. Another option is to request extra or larger payments to be made to go towards the loan.

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