Going to the car dealership, picking out a car, and being approved for a loan is a standard affair for millions of people. Auto loans have become a normal part of the way our society functions, and we hardly flinch at the thought of paying high interest on these loans – some of which can take up to six years to pay off.
If you have a high enough income to make your payments, it makes sense to take out a car loan, especially if you’re trying to repair, build, or boost your credit score. If you don’t have the income to support making regular payments on your car loan, you could find yourself sinking into further debt, even needing to declare bankruptcy, or worse – defaulting on your loan.
People are borrowing beyond their means
According to the Federal Reserve Bank of New York, auto loan debt in the U.S. has reached over $1.16 trillion, most of it owed by subprime borrowers – people with a credit score below 550.
Unfortunately, as the amount of debt steadily rises, defaults and delinquency rates are rising, too. Almost 4 percent of payments are 90 days late or more. The more people default on loans, the more interest rates will increase for everyone (even people with great credit and high income).
The auto industry has to make up for the lost income somewhere, so they’ll pass it on to everyone. Even though subprime borrowers will pay higher interest rates than people with excellent credit, rates are rising proportionately for both groups of people.
Making timely payments increases your credit score
To the average person, the idea of negotiating a car loan with a good interest rate can be daunting. Once the loan amount is established, the interest rate doesn’t seem to be too flexible unless you have a high credit score.
When you first take out your car loan, if you have a low credit score, your interest rate will be fairly high but as you make your monthly payments on time, that consistency contributes to building your credit. What this means is that as you make your payments and your credit score rises, you start to qualify for better interest rates. That’s when it makes sense to refinance your car loan.
There’s a trick to refinancing your car loan, however. You want to refinance before the majority of your loan has been paid off. That’s when lenders are most willing to refinance at better rates; when you still have payments to make, they know they can count on that income for a period of time. The longer you wait and the more you pay down your loan, the less attractive you are to lenders because you no longer represent long-term income to them; therefore, they have no incentive to negotiate a better interest rate for you.
Why lenders aren’t too worried about defaulted loans
It seems strange that lenders are approving people with low credit scores and lower incomes for loans. It doesn’t make sense to charge people with less income more interest. In fact, some lenders charge between 10-20 percent. If someone barely has the income to pay off the loan principal, where will they get the money for the interest? Besides, with so many people defaulting, the collections agencies will have to go through the process of repossession more often and that costs time and money.
What most people aren’t aware of is that cars are now being equipped with devices that allows collections agencies to disable the vehicle when a borrower falls behind on payments. That’s why lenders aren’t as worried as you might think. Although the devices are controversial and potentially dangerous for the consumer, they reduce risk for the lender. And since it’s easy for them to repossess a car, they can easily sell it to someone else.
Managing your means
If your car loan payments are too high, it doesn’t hurt to call other lenders to get information on refinancing. You might be able to refinance with the same lender, but usually you’ll find better success with a different lender. Your current lender will sell your debt to the new lender, and the new lender will see you as a source of new income so they will be more likely to offer you a better rate.
Of course, the best solution is to only take out a loan if you can afford the monthly payments. If you can’t, you might be better off buying a used car for less than half the price of a new car.