Car Loans

Aside from home purchases, car loans represent the second biggest type of purchase in terms of dollar value that most people make. While very few people can afford to buy a home outright due to the sheer costs of it and how many years it would take to save up that much, with automobile purchases, there is a lot more latitude here in terms of what one may spend, and therefore more options available.

Some people do save up for car purchases and pay for them out of their own savings, but this is not the norm, and almost all car purchases involve the buyer getting some sort of financing. Even those with the worst credit often will take out a loan to buy a car or get some other source of financing, and there is a whole industry that has built up to serve the poor credit auto financing market, with rates varying from a little higher than prime loans to very high.

Those with poor credit don’t generally do very well as far as building up savings goes, as this often indicates a lesser ability to manage money, as they, at one time anyway during the preceding few years, have not only been unable to save, but also unable to even meet their day to day cash flow obligations.

Whether those who have struggled with making ends meet should be considering adding to this burden by getting another loan is an open question, and while people’s circumstances differ, and some may have experienced temporary hardship which has been rectified since, this market does produce a lot of defaults and this is why we see rates in the 30’s or even higher being offered, and being accepted as well by many.

The desire to own a certain quality of car is well ingrained in modern western culture, and many people are sold enough that they don’t ever consider the practicality or value of buying new cars and trading them in after just a few years, they just do it and don’t even think about it.

The Costs and Benefits of Auto Loans

Automobile manufacturers do a phenomenal job at marketing their products, and in a society that is so driven to consume, there is perhaps nothing that we are so driven toward than car purchases. This is not to say that this is necessarily a bad thing, but it we should at least be considering the value that we get from these purchases and at least have some sort of vague idea about how much we should be spending on them to best suit our financial objectives and overall utility, our enjoyment of life from the money we earn in other words.

The first and most fundamental concern is ensuring that we are not putting ourselves in a position where we may not be able to afford the cost of the car purchase. People value things differently, and people certainly value the satisfaction and utility of car ownership differently, but in all cases there are more basic needs that need to be taken care of first, food and shelter for instance.

One may select various levels of spending on even food and shelter, they may choose to live in an inexpensive apartment and spend money on food frugally, turn the heat down in the winter or forego air conditioning in the summer, and all sorts of other cost cutting measures, as a way of managing their limited financial resources according to what they value more.

When one gets in a position where they end up defaulting on a loan, some of the time this may result from unforeseen circumstances, but often times, it is due to poor planning. There is enough latitude in the way that car loans are given out that one may get themselves in a position that they cannot afford to maintain their debt obligations, and we need to be careful to avoid these situations.

When you default on a car loan, at a minimum you have wrecked your credit for several years, and often you will lose the car as well, if it is put up as security for the loan, which it often is. Even if you do manage to pay it off regularly and on time, the burden of the payments may cause you to need to forego higher order preferences, for example to have to scrimp on things that resulted in more loss of enjoyment and utility than the extra money you spent on the particular car provided benefits to offset.

People don’t generally think very structurally at all about their personal finances, and while we really don’t need to take the approach an economist might, involving a bunch of calculations and much deliberation, we should at least be thinking about these decisions more than we typically do, and make at least a decent effort to try to decide whether spending extra on a car is going to be worth it for us or not.

We don’t need any great degree of accuracy here, as a general sense will do just fine. The mistakes that are made here tend to be on the gross side, where just thinking about things more, what one may be giving up with this particular car purchase, as well as what additional risks it may expose us to, will usually be more than enough.

The Practical Side of Car Loans

There are actually two main issues from a practical perspective that emerge with seeking to finance a car purchase, which are the cost of the car itself and the interest costs involved in paying it off.

We can combine these two by looking at the overall cost of the car though, the principal plus the financing, as well as other costs involved such as maintenance, fuel, insurance, and so on.

Some of these costs will be similar across many car choices and options, although others may not, and it’s important that we look at the total cost. Many people focus a lot on things like gas mileage for instance, and while that is a factor, it is just one, and it doesn’t make sense to pay a whole lot extra money on a car and pat yourself on the back that you’re going to get more miles per gallon, when it may have been wiser to just buy a lot cheaper car and save a lot more if that is really a main goal of yours.

What tends to happen with auto financing is that, given the ability to spend more and usually a lot more on the car, we end up doing just that, and may be spending much more than we need to or should in many cases.

There are two main reasons why people buy one car over another, with personal preferences being one of them, the amount of pleasure we will get out of the purchase for instance. The second is what we could call the practical side, the overall costs of the car ownership including financing.

To the extent that we are using these principles to decide on what car to buy and the amount we will be looking to borrow, if we are going to be guided by these two criteria, it’s important that we at least have a good general idea of how they should be impacting our decision. This is especially important if we’re using practicality as our guide.

There are many folks who have some real opinions here, but they may not have thought very much about them, for instance the idea that you should always buy new lest you just buy someone else’s problems.

In some situations, buying a used car may not make sense from an economic perspective, and the practical side of this equation always involves economic concerns, the real costs involved, versus things like the pleasure of driving a pretty car or one that might impress your neighbors.

Used cars will tend to cost more per mile for maintenance, especially since they don’t come with a factory warranty, although you can often get aftermarket warranties for used cars if you prefer. The cost of a factory warranty is priced in though, and it makes no sense to say that it’s great that you don’t have to worry about such things but forget the fact that you’ve paid a lot for this already up front.

If one is comparing a $30,000 car with a $10,000 one, and is worried about extra maintenance costs and this is a main factor in spending the extra $20,000, this view is in serious need of re-thinking. The real way to compare this is to add the cost of a warranty on the used car and see how this measures up.

Choosing the Type of Auto Financing

Once we’ve decided on the amount that we’re looking to finance with our car purchase, and also decide that we want to buy it now versus waiting and perhaps saving up to help with the purchase, we now need to decide what type of financing we’re going to look to get.

This is the easy part, as the primary goal here should be to look to get the best rate, which almost always involves getting a secured loan, where the lender places a lien on the car while the loan is outstanding.

Some people will use revolving credit to buy a car, and while this will generally involve a higher rate, unless they are using a home equity line of credit, which provides lower rates than both unsecured lines of credit and loans and even secured car loans, using a line of credit does involve more repayment flexibility.

With an installment loan, you either pay the full monthly payment or you default, while lines of credit offer you a lot more flexibility in how you pay it off. Lines of credit are revolving like credit cards, where you can pay down any amount during a month, pay it down as little as you want, don’t really make a net payment at all, and even borrow extra if you desire or need to.

The ideal setup, other than using a home equity line of credit, is to have a secured car loan and an unsecured line of credit as well, where the secured loan will get you a better rate, and the line of credit will add the flexibility.

The goal would be to pay down the loan in time, but should one need more cash flow, we can rely on the line of credit to provide that, for instance borrowing part of the loan payment during a current month if needed or desired.

More importantly, this approach allows us to more aggressively pay down the loan by making extra payments as we can, and not having to worry about regret should a need arise where we would want part or all of these extra payments back. We would instead borrow this from the line of credit and offset the payments that way, but only when necessary, and this would therefore provide us with the best of both worlds.

It is important that we carefully consider all factors and options when seeking a car loan. People don’t think much about these things generally, and while none of this is all that complicated, it involves more than just imagining how good the car will look in our driveway.