One of the biggest line items in a typical household budget is car expense, and one of the reasons it’s so large is because of car loans. After decades of easy credit, we’ve been conditioned to think of car loans as a normal part of the car buying process. Not many people even think to pay cash for a car anymore. I have a car, therefore I have a loan.
But is that the way we should be thinking? Are there deeper risks to having a car loan that we tend to gloss over? I think so. The loan you sign on for when you’re safely employed can quickly become unsustainable after just a few months of unemployment. And with job losses and extended periods of unemployment becoming the “new normal” we should be changing our assumptions about car loans.
What are some of the reasons you should avoid a loan and pay cash for your next car?
A loan puts your car at risk
Unlike credit cards – where the lender has no specific claim on your assets – if you fall behind on your car loan, your car can be repossessed. This reason alone should remove any casual notions we have about car loans. They’re higher risk than almost any other loan type! Even if your house is foreclosed on, there is an extended period of due process that can take a year or more in many states, giving you valuable time to maneuver. No such protections exist for a car loan; stop paying and the repossession process is pretty swift.
A car is a survival asset for most people
For most people, a car is critical to their ability to earn a living, if only for commuting. If the car is lost – which is much more likely during a period of extended unemployment—your ability to earn a living will be greatly impaired. You can lose your wide screen TV, your $3,000 deluxe treadmill or even your home and still be able to earn a living. Not so with a car; lose it and your job prospects collapse immediately.
The double car payment trap
One car loan is bad enough, but as a testament to the casual way people often see them, many households have two or more. All of the problems of one car loan are multiplied by the number of loans outstanding. In some households total car payments can exceed the monthly house payment.
High cash flow drain
A car is an expensive proposition to begin with; you already have insurance, gas, repairs and maintenance. A car payment magnifies all of this. In fact if you total up all the expenses you pay each year to own a car you’ll see why your money just seems to disappear into thin air. For most people, a car is the second most expensive budget item, after a home. By paying cash for a car, you cut this expense considerably.
Owing more on the car than the car is worth
This is also referred to as being “upside down” – for obvious reasons. Cars depreciate rapidly, so it’s possible to be upside down shortly after purchase, even after making a 20% down payment.
This situation creates at least two problems that I can think of. First, it limits your options if you want to sell the car or refinance the loan – you’re no longer talking about an 80% loan, but maybe a 110% or 120% loan. Or you could face a loss on sale.
Second is an insurance claim. In the event you’re involved in a crash and the insurance company totals your vehicle, they will only cover an amount up to the value of the car before the crash. That may mean a settlement that is not enough to payoff the loan, let alone provide for the down payment on a new car. Gap car insurance exists for this purpose, but few people purchase it unless the car is leased or the car is purchased with little or no money down – if even then.
Owing less on the car than it’s worth
On the surface I’ll admit that this one doesn’t seem to be a problem. But let’s imagine that you’ve been unemployed for about a year and you’ve fallen behind on your car payments. Your car is worth $15,000 but you still owe $5,000 on it, and the bank is repossessing it. You’ll lose a $15,000 car and the $10,000 equity you had in it will evaporate for the inability to pay a $5,000 loan.
Theoretically, the lender is supposed to return any surplus equity over to you after the loan is satisfied, but don’t count on it working out that way. For starters, they’ll fire sale the car to get their money quickly. Then they’ll add legal fees, back interest, and any garbage fees they can create to the settlement. Nope, don’t count on getting anything back.
Equity for your next car
The equity in the car you own today will probably make up most of the cash you pay on the next car you buy. By owning your car free and clear, not only do you maximize the amount of cash you have for the next purchase, but you also keep your options open to make the buy at any time. You won’t need to wait until the loan is paid, or worse, having to deal with the complications that come with selling an indebted car.
You don’t need a car loan if you work from home
Millions of people are now working from home, whether they’re self-employed or telecommuting. You don’t need to have a car loan if you work from home, in fact you don’t even need much of a car at all. A ten year old “beater” that works for short local hops is really all you need (you can rent a car for long trips if you don’t trust your beater to get you there). It makes no sense to borrow to pay for a car that you’re hardly using.
What’s the alternative to having a car loan?
Most obviously, don’t borrow to buy a car – paying cash is the way to go. Fortunately, there’s a car for every budget, especially if you can overcome the dreaded affliction newcaritus. And there are other ways to deal with car loans in the event you already have one.
- Buy only as much car as you can afford to pay cash for; it that’s $2,000 for a 15 year old car, then that’s what you can afford.
- Dedicate a savings account specifically to accumulate money for your next car.
- If you have a car loan now, make paying it off a priority, even ahead of your credit cards.
- If you have loans on two cars, make a priority of paying off the smallest as soon as possible – then go after the bigger one.
- If you do use a loan to buy a car, make the largest down payment possible and the term as short as possible, then pay it off early.
Have you ever thought about the risks of financing a car? What do you think about paying cash, even if that means buying an older, less expensive one?