Getting a new car is an exciting experience, so it’s no wonder that the number of car loans has increased by 75 percent between 2009 and 2018. Although this simply implies that more Americans view their cars as a necessity rather than a privilege, it’s also alarming to note that growing numbers of these borrowers are defaulting on their loans. So, it’s important for any new car buyer to first consider a few ground rules before taking on an auto loan that they may not be able to keep up with.
Rule No. 1: Consider Your Financial Position
It’s always better to spend a bit of time analyzing your finances before getting into debt, rather than having to refinance or worse — default on payments, which severely impacts your credit score.
List your monthly expenses and your monthly income. Then categorize your list of expenses into needs (such as housing, groceries, transport, etc., including your car payment), wants (such as entertainment, holiday expenses, etc.), and savings (such as long term investments and credit card payments).
Typically the ‘Needs’ part should take up around 50 percent of your income, while ‘Wants’ ought to constitute no more than 30 percent of your income, and ‘Savings’ should be 20 percent of your income. Adjust your lifestyle to follow this balanced budgeting approach and choose to set out no more than 15-20 percent of your income towards your monthly car payments. This is the safest method to ensure that you don’t end up defaulting on your car loan.
Rule No. 2: Consider Total Financing Costs
Now that you’ve determined a rough figure that you want to put down as a monthly payment, consider first how large of a loan you want to take out. The smaller the amount, the better it will be for you. This is where you would want to dip into savings to try and make a reasonably big down payment on your car, allowing you to take out a smaller car loan.
The next step is to look at the annual percentage rate or APR. If your credit score is low, your rate of interest will be quite high, but if it’s good, it will be minimal. So bear in mind that your credit score is extremely important.
Third, look at the term of the loan. A long-term loan will have you paying a much higher amount towards interest than if you chose a shorter term of payment. So adjust your loan amount within your monthly expenses, forego a few items in your wants list and ensure that your budget remains balanced while you pay a monthly installment that allows you a shorter term and a lower interest amount.
Rule No. 3: Read Financing Options
There are a few loans that are truly helpful to borrowers, but at the same time, there are predatory options aimed at low-income, low credit score individuals that make it easy for them to qualify for a high-interest loan, even if they will most likely default on their loan within a very short span of time.
The best way to avoid car payments that are too high is through budgeting and an honest look at your finances.