Have you ever celebrated a money boon with a big purchase? Maybe you were promoted at work or received a big raise. Maybe you won the lottery or got a large inheritance. Maybe you just found a big bag of money on the side of the road. In these situations, the most common celebratory item is a sleek, shiny new car.
But just like good luck can swoop in and make you feel invincible, bad luck can rush through just as quickly and tear your world apart. Maybe you get demoted or lose your job. Maybe the IRS doesn’t like the way you handled that big inheritance and levies some heavy fines. Either way, you find yourself trying to pay off a car loan you can no longer afford.
This is an all-too-common scenario – partly because people have a tendency to buy cars they can just barely afford, and partly because the average auto loan in the United States has been rising steadily for about a decade.
If you find yourself in this situation, don’t despair. It can feel like you’re drowning when one missed or late payment turns into another, but you have options to mitigate the situation and pull yourself out of trouble. Here are some of the best options for those who find themselves unable to make their car payments – and how to prevent it from happening the next time.
You can refinance the debt to get a lower monthly payment if you can’t afford the current payments. Typically, smart consumers will refinance their debt to a lower interest rate but keep making the same payments as they were before.
However, if the monthly payments are stifling, you can refinance the car loan to stretch out the term. For example, if you have three years left, you can choose a five-year term which will reduce your monthly payments. When you get back on your feet, you can go back to your old payments so you don’t pay more in interest than you need to.
This solution is only a partial fix, since you could end up paying more in interest over the life of the loan – but that’s a better option than defaulting on the loan or missing payments.
The type of refinancing deal you’ll find depends on your credit score and the amount you owe. Credit scores of 750 or higher will get the best rates, so double check your score before you refinance so you know if you’re really getting the best offers.
Look at credit unions and banks where you’re already a customer first. They could have the best rates, and it never hurts to work with a company who you’ve already established a trusting relationship with.
Before finalizing the auto loan, ask about any fees or penalties. Refinancing a loan can have lots of upfront costs, and you don’t want to pay more than you have to. Try to find a loan without prepayment penalties which will fine you if you pay off your loan faster than the agreed-upon term.
The worst part of a car loan is that most people need to have a vehicle to get to work. If you stop making payments on your medical bills, you’ll probably go into default and the debt will go into collections – but the bank can’t take away the medical care you already received. If you stop paying your auto loan, your car can be seized, leaving you stuck with no mode of transportation, putting your employment in jeopardy.
If you are struggling to make your car payments and can’t refinance the loan, try to refinance your other debts. For example, federal student loan payments have income-based options you can use if you’re having problems. Low earners will often have a $0 minimum payment, which can be useful if you need to catch up on other bills.
If you have a mortgage, you can also take out a home equity loan to pay off your car debt. Home equity loans have low interest rates because the bank uses your house as collateral. You could also refinance the house to lower your mortgage payment and give you more wiggle room.
One option is to pay off the debt by selling the car and using any savings you have to wipe out the debt and then buying a beater for a couple thousand dollars. For someone downsizing from a luxury vehicle, this option could be a hard pill to swallow, but you could free up hundreds of dollars a month.
Sell the car to a private party to get the best price and buy a used car. Whatever remains after that should be used to beef up your emergency fund or pay off high-interest debt.
Many dealerships convince you to spend more on a car by offering 0% financing or 1% interest. If you can finance a car for less than the cost of inflation, what’s the harm? But these low-interest financing offers often come with “gotcha” rules, such as the APR increasing to 18% if you miss a payment.
Being able to afford the payments doesn’t mean you can afford the item. Most of us could give up $200 a month if it meant having access to a private jet, but that doesn’t mean we own a jet.
Instead of tying up your finances for five years or more in a car, find one that you can afford to purchase in cash. Sure, you won’t get the latest model, but you’ll be debt-free and have no worries of what you’ll do if you lose your job or can’t afford to make the payments anymore.
Many people fall behind on car payments because something else comes up, like a surprise trip to the emergency room or a cross-country plane ticket to a relative’s funeral. These expenses can eat up your budget quickly. If you’re not careful, they can even affect how you pay for the basics like rent, groceries, and you guessed it – car payments.
Always have an emergency fund of three to six month’s worth of expenses to pay for unexpected events. That way, you won’t have to worry about choosing between paying your bills or an emergency root canal.
>> READ: Why You Need an Emergency Fund
A large down payment up front can prevent you from ever getting underwater on your car loan, leaving you stuck between a rock and a hard place. Ponying up a bigger down payment will make your monthly payment smaller and even decrease your interest rate. A down payment of at least 20% will get you the best rate and probably force you into choosing a more affordable car.
A good rule of thumb is not to spend more than 10-15% of your annual income on a vehicle. If you only earn $35,000 a year, that means you should only spend between $3,500 and $5,250 on a car per year. The less you spend, the less you have to worry about making payments if you lose your job or can’t work for an extended period of time.
When things are going well, take advantage of excess cash flow to make extra payments on your auto loan. You’ll pay off your loan early and spend less on interest overall. If times get bad, you can cut back on your extra payments.
You can also apply this approach to buying your next car. Rather than using a financial boon to justify a pricey auto loan, stash that money away until you have enough for a large down payment – or to buy the car outright. You may have to wait a little longer, but you’ll be avoiding potential catastrophe and limiting – or eliminating – the size of the debt you taken on. Trust us, in the long run you’ll be happy you waited.
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A car loan you can’t afford seems like a burden you can’t escape from, but everyone has options. As long as you’re honest about your situation, communicate with your lender and look into every possible option, you can find a way out that will leave you free from worry and stress.
Use this experience as a lesson to always borrow less than you think you can afford, so you don’t end up another debt you can’t handle. Or better yet, use this time to get debt free and boost your emergency fund, so you never have to rely on debt again.