3 Ways Car Loans Can Go Wrong — and How to Avoid Them

Beware these car loan pitfalls. One wrong turn can make the difference between building good credit or driving it into a ditch.

3 Ways Car Loans Can Go Wrong — and How to Avoid Them Photo by maxuser / Shutterstock.com

A new car loan can drive your credit ahead, cementing your reputation as a responsible borrower who can be trusted with major responsibility, including the much-coveted mortgage.

But take a wrong turn – even one late payment – and your credit score will sink, making it more difficult — and in some cases nearly impossible — to obtain credit in the future.

The time to guard against making such mistakes is before you sign a loan or even decide exactly which vehicle to buy.

So first consider these auto loan pitfalls to protect your credit. Then visit the Money Talks News Solutions Center, where you can search for car loan rates based on your needs and credit.

Unsure of your credit score? You should know it before applying for any type of loan, and you can get it for free from Credit Sesame.

1. Forgetting to factor in loan costs

While some advocate paying cash for vehicles, an auto loan is a great way to build credit — if it’s done right. Many auto buyers spend too much on loans because they look at the monthly payments, not the total cost of the car — including loan interest and finance charges.

Savvy borrowers shop for auto financing from credit unions, banks and other respected online lenders before they begin serious negotiations on a specific car. Knowing the total cost of your loan before signing on the dotted line is key to ensuring you don’t fall behind in payments or carry so much debt that lenders consider you a high risk.

2. Getting upside down on a loan

Long-term loans may make sense for those who can reasonably expect financial stability. But what if you buy a car based just on what you can pay on your current salary, and then you’re laid off? You may need to sell your car even though it has depreciated and is worth less than you owe on the loan. That’s called being upside down on your loan.

“There is no silver bullet that will magically get rid of the negative equity,” write Edmunds senior consumer advice editors. “Your options are to deal with the situation either now or later.”

To help reduce your odds of getting upside down, follow the 20/4/10 rule suggested by Interest.com and others:

  • Make a down payment of at least 20 percent.
  • Finance a car for no more than four years.
  • Don’t let your monthly vehicle expense — including principle, interest and insurance — exceed 10 percent of your gross income.

That way you’ll build credit without carrying an unwieldy amount of debt and have options if your financial situation changes.

3. Rolling over a loan without first doing the math

A common method for dealing with negative equity is to buy another car and finance it by rolling the amount currently owned into the new loan, according to Edmunds. Incentives could reduce the balance on the existing loan or even erase the negative equity, but the tradeoffs may not be worth it for everyone.

Edmunds’ example: “If a person was $1,500 upside down on the trade-in car and wanted to buy a new car that had a $2,500 rebate, he or she could erase the negative equity and still have $1,000 for a down payment on the new car. Note, however, that cars with heavy incentives tend to have lower resale value for at least three years, according to Edmunds pricing analysts. This means you will be upside down for a longer period of time.”

What’s your experience with financing car purchases? Share with us in comments below or on our Facebook page.

Disclosure: The information you read here is always objective. However, we sometimes receive compensation when you click links within our stories.

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