Buying A Car On Finance: Pros and Cons
Is financing a car right for you? The pros and cons of a car loan depend not only on your need for wheels, but also on your present financial condition and your future plans (especially if they involve the housing market).
Buying A Car On Finance Pros and Cons
Building a Credit Foundation
Financing a vehicle purchase can help you build a credit history that will elevate your score. FICO, which stands for Fair Isaac Corporation, bases 35 percent of your credit score on your credit payment history.
Banks, mortgage companies and other lenders lean on FICO scores in their their decisions to write loans and the terms for them.
A history of on-time payments helps you only if the lender or creditor reports it. Beware of “Buy Here, Pay Here” dealers or lenders who may keep your good work silent. Get an assurance from the dealer or lender (perhaps in the sales or credit agreement) that it will relay on-time or good payment information to the credit reporting agencies.
Save For Something Else
When you finance a car, you can hold those thousands of dollars you otherwise would have used for other uses – especially a down payment on a home. The size of a down payment determines what you have to borrow and can lower your house payment – and not merely the principal and interest part of it.
Unless you put down 20 percent of the purchase price, lenders will require you to carry private mortgage insurance until your loan balance falls to 80 percent of the home’s value. These insurers cover, not borrowers, but lenders who suffer losses because of defaults by borrowers.
As a rule of thumb, private mortgage insurance (PMI) runs from 0.3 percent to 1.5 percent of what you originally borrowed. For instance, on a $200,000 loan at a rate of 0.3 percent a year, you’ll pay $600 a year, or $50.00 a month, on PMI until you can drop it.
Vehicles are depreciating assets. In fact, a new car generally loses 19 percent of its value in the first year you own it. Half of this drop happens the moment you drive away from the dealership. When you save the money, you can have it available for assets, such as real estate, which can actually increase your net worth.
Yes, you can get tax write-offs by financing your vehicle purchase – if you use the equity in your home. You can deduct the interest on a home equity loan, generally up to a maximum loan amount of $100,000 ($50,000 if you’re married filing separately).
To take the mortgage-interest deduction, you must itemize. This makes sense only if your interest payments, plus other itemized deductions such as state and local taxes, employment expenses, medical expenses and charitable contributions, exceed the standard (or default) deduction.
When you put up your home equity for a car, you reduce the equity in your home. Downturns in the economy and other forces can drive down your home’s value. You risk losing out on equity if you have to sell quickly, say because your moving for a new job, or having an “underwater home,” which means you owe more for mortgages than the home is worth.
Related: How To Get Approved For A Car Lease
A car loan adds a debt obligation to your budget and too much debt can hamper your ability to meet the costs of living and to get a home loan.
Keep your car payment to a maximum of 20 percent of disposable income, which takes into account living expenses and other debt payments. A debt-to-income ratio of 43 percent is the highest at which most banks will even consider you for a loan.
Higher down payments and higher credit scores can lower the monthly payment. Online loan calculators can estimate your monthly payment based on factors such as down payments, interest rates, trade-ins and vehicle price.
Find a manufacturer or finance company whose payment calculator includes an input for credit history, so you can see how your credit scores impact your monthly payment.
The Car Really Costs More
Financing comes at a cost and it is called interest. Online car loan calculators not only give you an idea of your monthly payments, but also a ballpark figure of the total interest and the real cost of a car you finance. The inputs are the amount you’re financing, the length of the loan and the interest rate.
The interest can significantly accumulate, especially if you have poor credit. Car buyers in this lot could face interest rates as high as 10 to 15 percent, which translate to payments well north of $600 for a forty-eight month loan.
Stretching the loan for a longer period may reduce the monthly payment, but will likely mean you pay more in interest.
For example, turning a four-year loan of $25,000 that carriers a 6.9 percent interest to a seven-year one adds $2,912 to your interest.
Related: Why Do Cars Depreciate So Quickly?
As you’ve read by now, cars depreciate in value — to the tune of as much as 19 percent in the first year. Add to that a long-term loan that accumulates interest, you might owe more on the car than it’s worth.
When it’s time to change vehicles, you’ll have an upside-down car and have to roll over that deficit into a new loan. In effect, you’re paying for two cars on one loan.
Financing a car has its advantages — especially if you have strong credit. To get low or manageable payments and avoid problems, such as upside-down car loans or mounting interest, take these steps to improve your credit history and score:
*Check your credit report for errors. Go to AnnualCreditReport.com to get your free report from each of the reporting agencies. You can ask in writing the for bureaus to correct the errors. You can find a sample dispute letter here .
*Lower the debt to credit limit ratios by paying off credit cards faster and keep credit cards you have paid off open.
Whether you pay cash or finance, consider buying a used or pre-owned vehicle if your finances or credit history makes a new car unaffordable. Now that you know about buying a car on finance pros and cons, what have you decided? Did we miss anything?