March 18, 2016
Consumers who choose smaller loans by purchasing less expensive cars can take advantage of the years where they lack a payment, instead diverting those funds into their retirement portfolio.
Many consumers wind up with high monthly car payments, because they purchased vehicles out of their price range and viewed monthly payments as a guide to determine how much to spend. Despite the fact that interest rates are still low, experts recommend following the “20/4/10” rule, which calls for the following:
- a 20% down payment
- financing to last no longer than four years
- principal, interest and insurance of the car not to exceed 10% of a person’s gross income
Drivers should be most adamant about following one rule of thumb — not taking out a car loan for more than five years, said Greg McBride, chief financial analyst for by Bankrate, the North Palm Beach, Fla.-based financial content company. Dragging out loans can be more expensive in the long run.
Putting down 10% for a new car and 20% for a used car gives consumers a “cushion considering the rapid depreciation after you buy the vehicle,” McBride said.
When car owners encounter a deal where they are not able to limit their auto expenses to 10% of their gross income and pay off the loan in five years, they need to seek more affordable options, said J.J. Montanaro, a certified financial planner at USAA, a San Antonio, Texas-based financial institution.
“Don’t get caught in the trap of making the car loan fit into your budget simply by going for a longer term loan,” he said.
How to Boost Retirement
Allocating the money you spend each month on your car payment into your 401(k) or IRA once you have paid off the loan helps consumers increase their retirement substantially.
“I love the idea of driving your car for twice as long as the length of your loan,” Montanaro said. “Let’s say you get a four-year loan and use the money that was being used as a payment during the second four years to bulk up savings or pay down other debts. You could make some real financial headway.”
While incurring debt is a necessity for many consumers, the majority of people can give themselves a “raise” by lowering their expenses and reducing the amount of their purchases, said C.J. Brott, founder of Capital Ideas, a registered investment adviser in Dallas, and a portfolio manager with Covestor, the online investing marketplace.
“This works really well when you are young and have the power of compounding on your side,” he said. “After all, time is money,” he said.
Missed a Car Payment, Missed Retirement Opportunity
The number of auto loans that are delinquent for 90 days or more late remained steady at 3.4% for both the third and fourth quarters of 2015, compared to other debt, according to the Federal Reserve Bank of New York.
Consumers who purchase cars within their budgets are less at risk of falling behind on their payments. Drivers who are facing delinquent car payments should start by negotiating with the lender instead of evading the issue.
Depending on the lender, some are less likely to negotiate with consumers on missed payments and the consequences are more severe compared to credit card debt, said Bruce McClary, spokesperson for the National Foundation for Credit Counseling, a Washington, D.C.-based nonprofit organization.
“Cars really belong to the bank until you receive the title,” he said.
Some banks will repossess cars after missing a handful of payments. Consumers who believe they are likely to miss the first payment should call ahead before it is late, McClary said.
“Be proactive and don’t wait for the lender to call you about the car loan,” he said. “Make the call if you think you will miss the payment.”
Some consumers are opting for longer-term loans and some of them extend as far out as 72 months, which can spell trouble for consumers since many of their vehicles will be upside down on their loans before they reach the end of the six years. Some consumers will find themselves in situations where their car is worth less than the amount of the loan, said McClary.
“Car loans can not be negotiated like credit cards through a debt management plan offered at a non-profit credit counseling agency,” he said. “Some lenders will work out a plan to get you back on track. The creditor can just back the car out of the driveway if you miss too many payments.”
After 90 days of not making any kind of a car payment, the lender will definitely send your account to collections and the car will be repossessed, said Katie Ross, education and development manager for American Consumer Credit Counseling, an Auburndale, Mass.-based financial education nonprofit organization.
Once there’s a mindset shift in a consumer’s outlook on his car budget — one focused on increasing affordability in order to increase retirement contributions — a person can recognize the importance of frugality with regard to long-term financial plan.