Key takeaways
- An auto loan can benefit you because it spreads out the expense of the car, leads to ownership and can help you improve your credit score.
- Some drawbacks to watch out for include being stuck with the same car for longer, possibly expensive monthly payments and the risk of damaging your finances.
- You can also consider car loan alternatives like leasing, using savings, tapping into your 401(k) or taking out a personal loan, though some of these options can be risky.
An auto loan can help you minimize the upfront expenses associated with buying a car by allowing you to spread the cost of ownership over several years of installment payments. However, there are some drawbacks to consider when purchasing this way, including the impact of monthly car payments on your budget for years to come.
And during steep interest rate environments, auto loan rates can also mean you’re paying significantly more for a vehicle than if you were to pay cash instead. With the average new car price hovering around $48,644 as of June, the cost of finance charges can really add up over time. Before purchasing a new car, take some time to understand whether financing is the most cost-effective approach.
Pros and cons of financing a car: Quick look
Pros of taking out an auto loan
- Spreads out the expense over years.
- Can help afford a better car.
- You’ll own the car after you pay off the loan.
- Can help improve your credit score.
Cons of taking out an auto loan
- Monthly payments might be expensive.
- There’s a risk of damaging your finances.
- The vehicle’s value depreciates while you’re still paying.
- You’ll be stuck with the same car for longer.
Benefits of taking out an auto loan
Though there are some drawbacks, securing an auto loan also comes with perks that other ways of getting a car do not.
1. Spreads out the expense
Few drivers can purchase a car with cash. An auto loan reduces the amount you spend upfront, swapping a big one-time expense for a smaller ongoing one.
It also leaves you with money in the bank to use for other purposes. Draining your savings leaves you without an emergency fund, which could come back to bite you in the future.
2. Afford a better car
Financing a car might mean a higher-end option fits your budget, but it’s still essential to determine how much car you can afford to finance. Generally, this number will look much better than you could pay in cash.
Bankrate tip
While you can get behind the wheel of a nicer car, beware of overspending. Experts recommend spending no more than 20 percent of your take-home pay on your car loan plus other car-related expenses like insurance and fuel.
3. You own the car at the end
Many consider leasing versus buying when looking into new vehicles. While leasing can put you behind the wheel at a lower monthly cost, you should consider the end-game difference.
Getting an auto loan leaves you with a vehicle you own. Leasing does not (unless you choose to buy out your lease). Once you pay off the loan, you can use it for as long as you’d like and eventually sell it to recoup some of your costs.
4. May improve your credit score
Your payment history makes up 35 percent of your FICO score. If you can keep up each month, your credit score should increase over the loan’s term.
Your credit mix — the different types of credit you have — also plays a small role in your credit score. Adding an auto loan can diversify your credit mix and slightly boost your score.
Disadvantages of taking out an auto loan
Getting an auto loan is one of the most effective ways to afford a car, but it has downsides.
1. Monthly payments can be expensive
Even if you finance a vehicle that fits your budget, your monthly payment can be steep. On average, drivers pay $735 per month for new vehicles, according to Experian. And this high cost is on top of insurance, which averages $2,278 annually, according to Bankrate data.
2. Risk of damaging your finances
Falling behind on your auto loan payments will lead to trouble. Even one missed payment will hurt your credit score. And multiple missed payments can lead to your vehicle being repossessed.
This is because, for most auto loans, your vehicle secures the loan. If you cannot make payments, the lender technically owns it — and will repossess it to recoup its losses. But even if you chose an unsecured auto loan, you could be taken to court for missed payments.
3. Your vehicle’s value depreciates
Your vehicle will depreciate the moment you drive off the lot. A car may lose 20 percent of its value in the first year. If you have a high interest rate, you could owe more than your car is worth — what’s called being upside-down on your loan.
Being upside-down on a car loan is a bad situation. This means that you can’t sell the car unless you have enough savings to make up the difference. It could also cause problems if you get into an accident and total the car. If you don’t have a policy that pays off the full amount of your loan, your insurance payment likely won’t be enough.
4. Stuck with the same car for longer
Unlike with leasing, the vehicle you sign off on is the vehicle you will be operating for the foreseeable future. These days, long loans are the norm, with the average auto loan for a new car lasting 67.62 months, according to Experian.
If you opt for a long loan term, you could be stuck with the same car for longer than you might want. This is especially true if you imagine yourself changing your mind, as selling a car with a lien can be complicated.
Should I finance a car?
After you compare the pros and cons of auto loans, answer some questions about your finances and your needs for the vehicle.
- What can I afford? Unless you can afford your dream car upfront, an auto loan is the most effective way to get a vehicle. Use an auto loan calculator to estimate your expected monthly cost and ensure you can afford it.
- Do I need to build my credit? Signing off on a loan you know you can pay off can be a great way to watch your credit score grow.
- How long do I want this vehicle? Auto loans tend to last between 36 and 84 months. At the end of your loan term, the vehicle is yours. So if you intend to swap cars frequently, leasing may be a better option.
Financing a car vs. paying in cash
Financing a car can be a convenient way to cover the costs of a new car purchase. It can especially make sense in certain circ*mstances, including when you do not have the money upfront to buy the car with cash. In cases where using cash to make the purchase would wipe out all of your liquid savings, it may also be wiser to consider financing and leave your savings for emergencies and other important expenses.
If saving money on the overall cost of the car purchase is paramount to you, financing will not allow you to achieve this goal. The interest charges on a loan mean you’ll spend more than had you paid in cash. Additionally, if you’re debt averse or do not want to impact your budget for years to come with a monthly car payment, then a cash purchase may be your best bet.
The bottom line
Deciding whether an auto loan is right for you depends on your financial state and how long you want the vehicle. Crunch the numbers to determine how much you will be spending out of pocket over the life of an auto loan versus paying cash to purchase a car.
If you find that vehicle financing is the best approach, take the time to research auto loan offers from several different lenders. Do your homework by learninghow to get the best auto loan rate.
