Auto loan balances increased by $10 billion in the first quarter of 2023. As new vehicle prices stay high, averaging $48,275 in April, it seems many are considering vehicle financing as the best way to get behind the wheel.
But loans of any sort come with risks. While you will have the ability to afford a better vehicle, it can leave at risk of damaging your finances. Before comparing auto loans, take some time to understand the pros and cons they offer.
Benefits of taking out an auto loan
Besides getting behind the wheel of a vehicle, securing an auto loan comes with perks that other ways of getting a car do not.
Spreads out the expense
Purchasing a vehicle up-front in cash is a choice that not many drivers cannot reasonably make. The costs add up and can make affording the vehicle you want nearly impossible. Signing off on a loan reduces the amount you spend upfront and instead spreads it out, making it much more accessible.
It also leaves you with money in the bank to use for other purposes. Draining your savings leaves you without an emergency fund, which could come back to bite you in the future.
Afford a better car
Depending on the type of vehicle you have your sights set on, financing it might allow a higher-end option to fit your budget. Before setting out to the car dealership with a loan in hand, determine how much car you can afford to finance. Generally, this number will look much better than what you could pay in cash.
While you can get behind the wheel of a nicer car, beware of overspending. Experts recommend spending no more than 20 percent of your take-home pay on your car loan and other car-related expenses, like insurance.
You own the car at the end
Many consider leasing versus buying when seeking a vehicle. While leasing can put you behind the wheel at a lower monthly cost, you should consider the end-game difference.
Getting an auto loan leaves you with a vehicle you own, whereas leasing does not (unless you choose to buy out your lease). Once you pay off the loan, you’re free to keep using it for as long as you’d like and eventually sell it to recoup some of your costs.
Plus, you can modify a car you’re financing as you like, even before you pay it off. You don’t have that option while leasing.
May improve your credit score
Your payment history makes up 35 percent of your FICO score. If you can keep up each month, your credit score should increase over the loan’s lifetime.
Credit mix, the different types of credit you have, also plays a small role in your credit score. Adding an auto loan can diversify your credit mix and boost your score slightly.
Disadvantages of taking out an auto loan
Getting an auto loan is one of the most effective ways to afford a car, but it has downsides. These aspects of vehicle financing could leave you in unfortunate circumstances.
Monthly payments can be expensive
Even if you finance a vehicle that fits your budget, your monthly payment can be steep. On average, drivers are paying $725 per month for new vehicles, according to Experian. And this high cost is on top of insurance, which averages $2,014 annually, according to Bankrate data.
Risk of damaging your finances
Falling behind on your auto loan payments could lead to trouble. Aside from your credit score taking a hit, securing other products like loans or credit cards might be challenging if you prove to be a poor borrower. Above all, missed payments or defaulting mean you could lose your vehicle.
Your vehicle’s value depreciates
Your vehicle begins to depreciate the moment you drive off the lot. Vehicles may lose 20 percent of their value in the first year. If you have a high interest rate, you could end up owing more than your car is worth — what’s called being upside-down on your loan.
Being upside down on a car loan is a bad situation. It means that you can’t sell the car unless you have enough savings to make up the difference. It could also cause problems if you get into an accident and total the car. If you don’t have a policy that pays off the loan, your insurance payment likely won’t pay off the balance.
Stuck with the same car for longer
Unlike with leasing, the vehicle you sign off on is the vehicle you will be operating for the foreseeable future. These days, long loans are the norm, with the average auto loan for a new car lasting 68.6 months, according to Experian.
If you opt for a long loan term, you could be stuck with the same car for longer than you might want. This is especially true if you imagine yourself changing your mind, as selling a car with a lien is a complicated act.
Is an auto loan right for me?
After you compare the pros and cons of auto loans, answer some questions about your financial well-being and needs for the vehicle.
What can I afford? Unless you have the cash to afford your dream car upfront, an auto loan is the most effective way to get a vehicle. To ensure you can afford the loan, use a calculator to find the expected monthly cost.
Do I need to build my credit? Signing off on a loan you know you can pay off can be a great way to watch your credit score grow while benefiting from vehicle ownership.
How long do I want this vehicle? Auto loans tend to last between 36 and 84 months. And at your loan’s end, the vehicle is all yours. So if you intend to swap cars frequently, buying through an auto loan might not be the best move.
Auto loan alternatives
Signing off on an auto loan may be the most obvious way to get a vehicle, but it is not the only way. Consider whether an alternative to traditional vehicle financing is better for you.
Leasing a car. Although leasing carries restrictions that buying does not, it costs less each month. This option is best for the driver who wants to afford a luxury vehicle without being stuck with one set of keys for years to come.
Buying with your savings. Dipping into your savings account can help you to afford a vehicle or put more down on the down payment, lowering your all-in cost. If you choose this route, be sure you still have enough to cover an emergency fund.
Using a credit card. Before showing up in the dealer’s office with a card in hand, you must first take some steps to ensure it is allowed by your creditor. In this case, it is also important to pay attention to your credit utilization rate to be sure you don’t damage your credit score.
Tapping into your 401(k). Using the money in your retirement fund can be risky and might even delay your retirement. But if you have a stable job and can stay within your budget, it could be an effective move.
Using a personal loan to buy a car. Just as you can use a personal loan to cover the cost of unexpected expenses, you can use one to pay for your vehicle. If you take this route, prepare for higher rates and shorter terms, as personal loans are unsecured. For example, LightStream is an online personal lender that also offers auto loans.
The bottom line
Deciding if an auto loan is right for you depends on understanding your financial state and how long you want the vehicle. And if vehicle financing is right for you, do your homework ahead of time by understanding how to get the best auto loan rate.