Achieving Your Goals: The Short-Term Decision for Long-Term Wins
Buying a car – exciting and a little daunting, right? Especially when you start crunching the numbers and facing those financing decisions. Should you stretch for that dream ride and stomach a higher interest rate? Or opt for a more budget-friendly vehicle or put down a bigger chunk of cash? And what if this is your very first foray into the world of car loans? Let’s unpack these options and help you navigate the trade-offs.
The Allure (and Risk) of a Higher Price Car with a Higher Payment and Interest Rate
The scenario often goes like this: you’ve found a car you like, but the loan amount and monthly payments are above the comfort zone and lenders are gonna require a higher interest rate. Lenders look at two key ratios to determine your interest rate ratios: 1) your payment-to-income ratio, which is the new car payment divided by your income. So if the new car payment is $500 and your monthly gross income is $5,000, your ratio is 10%, which is a good goal. A ratio above 14% starts to enter the danger zone and lenders need to price for it. And 2) is the loan-to-value, which is the amount of the loan divided by the vehicle’s value, so if the loan is $20,000 and the car’s value is $15,000, your LTV would be 133%, which is on the high-side of where mainstream lenders prefer to be. You really want to be at 120% or less. The higher each of these ratios are, fewer lenders will approve the loan, and those that do will charge a higher rate. The potential upside? Avoiding dipping too deeply into your savings for a down payment. If you are feeling good about your job and you expect your income to increase, the higher monthly payments could be more manageable over time, and if you don’t have established good credit, you may see a nice benefit from refinancing down-the-road.
The refi thinking is, after you make 9-12 on-time payments, prove your creditworthiness, your credit score will boost and you can then snag a lower interest rate, reducing your monthly payment. Refinancing has never been easier to accomplish with several online options.
While this strategy can work, it’s crucial to understand the potential pitfalls:
- More Interest, Slower Equity Build: In the initial months, a larger portion of your higher payment goes towards interest, not reducing the principal balance. This means you’re building equity in the car at a slower pace.
- Depreciation Dilemma: Cars are notorious for depreciating, especially in the early years. If your loan balance decreases slower than the car’s value, you could find yourself in a negative equity situation – owing more than the car is worth. This can make refinancing, trading or selling the vehicle down the line more complicated.
- Refinancing Isn’t Guaranteed: While more lenders are offering it, refinancing isn’t a sure thing. Interest rates could be less favorable in the future, or your loan-to-value may increase above what a lender is willing to approve, making you ineligible for a better loan.
- Consider the Risks of a Used Luxury Car: Yeah, you would feel and look good in that 5 year old BMW that has 100,000 miles on it, but how would you feel if it needed a $5,000 repair? Especially if you are paying a higher interest rate and need to build credit, the better move may be to buy a car that is reliable and well within your budget that will put you in a better position in a couple of years when you have established good car credit.
The Long Term Play of a Lower Price Car to Boost Your Credit
On the other hand, opting for a less expensive vehicle and putting down a larger down payment. This strategy leads to a lower loan amount and a better interest rate from the get-go, and the combination means you will be paying less in interest and more to reduce your loan balance.
The benefits here are clearer:
- Lower Monthly Payments: Less borrowed money means smaller, more manageable monthly obligations, and a lower interest rate.
- Faster Equity Build: With a lower interest rate, more of each payment goes towards reducing your loan balance, helping you build equity faster.
- Reduced Interest Costs: Over the life of the loan, you’ll likely pay significantly less in interest charges.
- Less Risk of Negative Equity: A larger down payment provides the lender more security to offer a lower interest rate with more affordable payments so you can comfortably achieve success in boosting your credit profile.
First Car? Consider the Credit-Building Stepping Stone
If this is your first time financing a vehicle, you’re in a unique position to build your credit history. A car loan, with consistent on-time payments, is a powerful tool for establishing and improving your credit score.
In this scenario, it might be wise to prioritize getting a car loan and building that positive payment history over getting your dream car right away. Consider a reliable, more affordable vehicle that you can comfortably manage the payments on. Think of it as a stepping stone. After a year or two of responsible payments, you’ll likely have a stronger credit profile, opening doors to better financing options when you’re ready to upgrade.
Making the Right Choice for You
Ultimately, the “best” option depends on your individual financial situation, your risk tolerance, and your long-term goals. Ask yourself these questions:
- What’s my current budget and what monthly payment and vehicle price can I realistically afford without stretching myself thin? A good ratio to search for vehicles is multiplying your monthly gross income by 4.5 to determine what the selling price goal is.
- How much do I have saved that can go towards a down payment and how long would it take to replace? Let’s face it, saving money is difficult and has many benefits. You could be better off paying a higher interest rate and holding on to your savings.
- What’s my current credit score and how would improving my score help with getting credit in the future, and the other benefits of renting an apartment or the price of insurance? A car loan is often the best way to boost your credit which will open doors for you.
- Am I comfortable with the uncertainty of potentially needing to refinance?
Carefully weigh the pros and cons of each approach. Step away from the emotional charge of getting what you want today and not fully considering the loan has 72 payments. Don’t just focus on the immediate gratification of getting the car you want. Consider the long-term financial implications and choose the path that sets you up for the most financial success down the road. Sometimes, the less glamorous choice now can lead to better opportunities later.