And depending on the type of car you buy, you could spend anywhere from a few thousand to several hundred thousand dollars on a new car. Of course with that shiny new car often comes with a car loan and monthly payments.
My car loan was the last thing I paid off before I became debt-free. I got into the car loan when I traded in my first car — with no car payment — for a brand new car right off the lot.
Not a very smart decision, I know. If you’re anything like me, having a reliable and good-looking car is a nice thing to have.
But what happens when you buy a new car while still paying off your old car loan?
Understand the Car Loan Debt Trap
When you roll the balance of your old car loan into your new car loan, this begins a dangerous cycle. Sometimes this situation is unavoidable, like for instance when your current car gets totaled or damaged and you’re forced to buy a new one.
The first thing you need to do before you can get out of the car loan trap, is to determine the status of the situation and why you’re here in the first place.
More than 70 percent of all car purchases are bought with borrowed money. - Source
Your car is considered an asset, but unlike a home which increases in value, the moment your car is driven off a lot the value goes down. For this reason you’ll find yourself “upside down” or “underwater” on your car loan — meaning you owe more than the car is worth.
Here are some of the reasons many of us fall into the trap of car debt:
- The cost of buying a car has become increasingly expensive
- Companies are very clever at marketing the image of driving an expensive car
- Lenders offer car loans for up to 7 years, which means you’re in debt much longer
It’s true, 45 percent of all new car loans today are for more than 6 years. – Source
Keeping a car around for more than 4 years seems like a stretch, much less 6 or 7, which means that we are constantly having to buy or trade in our old cars for a newer one with credit.
How Much is Your Car Worth?
Now that we know why and how you got into this situation, it’s time to take steps to stop the madness.
Start by determining how much your current car is worth. You can use sites like Kelly Blue Book or Edmunds for free, to accurately find out your car’s current value. You need to be honest in the condition of your car, it’s history and the exact mileage so you get the best valuation possible.
How Much Do You Owe?
Next up is finding out exactly how much you owe. Contact your local bank or auto loan company and ask for the “payoff” balance. You can then compare this figure to the estimated value price of what your car is worth.
Dump Your Car Loan and Escape the Debt Cycle
Keep the car for as long (or longer) than your loan. If your car loan is for 5 years, then you should plan to keep the car at least until your loan is paid in full. This will not only help you avoid the auto loan debt cycle, but remind you to choose a dependable car that’s worth the money.
Refinance your debt with a local bank or credit union. Local banks often have lower interest rates than dealerships, so check with your community bank or credit union to see if you can refinance your loan. I did this with my car, and I saved over 2% in interest every month! This will help you pay your balance down faster, since more money goes towards principal and not interest.
Throw any extra money towards the car loan. Finally, the best way to escape the car loan debt cycle is to do whatever you can to make extra money. There are two main ways you can do this:
- Sell items online, at yard sales or consignment
- Work overtime, a second job or do freelance work
Selling some high-priced items like furniture, electronics or jewelry can help jump start getting you out of this vicious cycle. Or if you’d rather make some extra money you could always work overtime, find a second job, or start a part-time business from home.
How to Save for a Car and Pay Cash
Once the loan is paid, keep making the payments — to yourself. Since you’re so used to sending in a payment for your car every month, continue paying the same amount but set it aside in a separate account to buy your next car. Similar to the concept of paying yourself first. Then…
Save up to buy your next car with cash. When the inevitable time comes that you need to replace your car, you’ll be prepared because you’ve saved up enough cash — plus any trade-in value — to buy a car without taking on a car loan. It may not be a new car, but you will have escaped the cycle of the car loan trap!
Have you escaped the auto loan debt cycle? Have you decided to save for a car and pay cash? What’s your opinion on the car loan and paying cash?