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When Buying A Car, Is There An Ideal Loan Amount To Take Out?

A car is less a luxury and more a necessity. It’s a means of getting to work or getting to a vacation spot. It’s how you get to a store or get away for the day. It’s a way to meet up with family or friends.

On average, a car is the second-most expensive purchase Americans make, but a  key part of successfully budgeting for the purchase of one is taking into account more than just the upfront price of the vehicle. It’s estimated that nearly 43% of Americans fall into debt because of car bills. According to a 2020 Lending Tree survey, a surprising 28% of drivers say they wouldn’t be able to manage a $500 car repair without going into debt. 

But armed with a few tips about how best to purchase a car – and take out a car loan – can help make the difference between driving yourself further into debt, or cruising to carefree auto ownership.

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Fixed Expenses Count…

According to Olivier Boyd, a licensed insolvency trustee at Canadian professional accounting firm MNP, prioritizing fixed expenses is a must. “You should be able to make ends meet and make sure all your other fixed expenses are covered,” Boyd advises. “Anything above that, then you’re entering a territory where it’s probably going to be that you have to be sacrificing something else.”

In general, financial advisors suggest that you should count on setting aside about 10% to 20% of your gross pay for each vehicle, each year. For example, someone earning $30,000 annually should consider budgeting no more than $400 per month after taxes, deductions, and factoring in the insurance, Boyd says.

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…And You Should Count On Unexpected Expenses, Too

When you’re considering taking out a car loan, be sure to factor in the loan’s interest rate, which will also impact your budget. Brian P. Doyle, president, and co-founder of Canadian insolvency firm Doyle Salewski Inc. believes it’s important to set aside a sum of money in an “emergency stash,” which is highly recommended for owners of older cars that might require a repair or two…or three.

Doyle encourages car owners to keep an eye on how much money they have available to cover unexpected car expenses. “These [incidents] are a part of life, and people don’t factor that into their budgets, so they don’t have the cushion,” Doyle says. “They often budget themselves down to, you know, the smallest amounts.”

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Steer Clear Of Predatory Loan Interest Rates & Say No To Negative Equity

It’s not unusual for auto loans to come with interest rates in the range of 6% to 8%; rates higher than that relegate buyers to the “risky category or second-tier lending, the most common term we are hearing,” says Boyd.

The Consumer Financial Protection Bureau reports that Americans are carrying a total of $1.4 trillion in auto loan debt, an amount expected to increase as car prices continue to rise. Car dealerships and independent lenders sometimes offer what appears to be easy financing, but the terms of the sale could result in bad credit for buyers. If you’re looking to take out a loan in order to purchase a vehicle, consider reputable bank programs that offer reasonable interest rates and manageable payment terms.

Negative equity happens when a buyer purchases a new car but hasn’t paid back what’s owed on their previous vehicle. The result? Drivers can end up defaulting on their loans because they’re now paying for two cars – a significant financial burden.

Having a manageable loan means knowing your financial limits, both in the present and the future. Almost 60% of recent buyers don’t research auto financing before purchasing their car, according to a study from peer-to-peer lending company LendingClub. Knowledge is power – and it can also be a powerful tool that can help you from sliding slowly into auto ownership debt.

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Words Matter

Doyle cautions people about overlooking hidden costs that can escalate over the months and years. “There are many [auto dealers] out there now who are still reputable, but there are some out there which are predatory, and that’s why people have to be careful,” Doyle cautions. Payday loans, in particular, serve as a cautionary tale.

Be sure to review all of your car loan documents, even if you’re borrowing from a reputable lender, in order to avoid hidden or surprise costs that can throw your financial plan off track. According to Doyle, before you make a car purchase and sign on the dotted line for a loan, know the interest rate, and be aware of any penalties or administration charges. Doyle also suggests asking questions such as  “Are you getting less for your trade-in than the true market value?”

In addition, don’t be afraid to question what will happen should you miss a car payment. Some car financing deals offer plans where a buyer won’t be required to pay interest for a year; however, if even just one payment is missed after the year-long offer has expired, the buyer could be responsible for high interest on any remaining loan payments.