4 Ways Car Loans Can Go Wrong and How to Avoid Them

Signing all the paperwork

By Nancy Dunham

Your new car loan can drive your credit ahead, cementing your reputation as a responsible borrower who can be trusted with major responsibility including the much-coveted mortgage.

But take a wrong turn – even one late payment – and your credit score will sink, making future credit more difficult to obtain — and in some cases nearly impossible.

And now is the time to guard against making such mistakes. The rebound in the stock market has brought about a "manifestation of the wealth effect," Robert Johnson, president of The American College of Financial Services in Bryn Mawr, Pennsylvania, told Main Street.

Basically the stock market's bullish cycle makes consumers feel wealthier and more confident making large discretionary purchases, he said.

Before you sign on the dotted line for that new or new-to-you car, consider these auto loan pitfalls to protect your credit.

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1. Getting in over your head

Sure, the price of the car is plain to see — it's posted on the windshield, right? — but it's easy to end up paying more than you intended. Some dealers offer very low car prices because they make their money on high finance rates, notes Bankrate. Savvy borrowers shop for auto financing from credit unions, banks and other respected online lenders before they begin serious negotiations on the exact car. Knowing the total of your purchase – including all extras and finance charges – is key to ensuring you don't fall behind in payments or carry so much debt that lenders consider you a high risk.

2. Forgetting to factor in loan costs

While some advocate paying cash for vehicles, an auto loan is a great way to build credit if it's done right.

But many auto loans just don't make good financial sense. Many auto buyers spend too much on loans because they look at the monthly payments, not the total cost of the car — including interest on a loan. A better bet: Follow the 20/4/10 rule suggested by Interest.com and others. Make a down payment of at least 20 percent, finance a car for no more than four years and don't let your monthly vehicle expense (including principle, interest and insurance) exceed 10 percent of your gross income. That way you'll build credit without carrying an unwieldy amount of debt and have options if your financial situation changes.

3. Getting upside down on a loan

Long-term loans may make sense for those who can reasonably expect financial stability. But what if you buy a car based just on what you can pay on your current salary and then you're laid off? You may need to sell your car even though it is worth less than you owe on the loan. That's called being upside down on your loan. "There is no silver bullet that will magically get rid of the negative equity," wrote auto expert Phil Reed, former consumer advice editor for Edmunds.com. "Your options are to deal with the situation either now or later." What that means: Keep your car at least until you reach a break-even point in the loan. Sell the car and find a way to make up the difference on the loan. Or face repossession and watch your credit take a major hit that might be irreparable for years to come.

4. Rolling over a loan without first doing the math

Another way to eliminate negative equity is to buy another car in which the dealership rolls the amount currently owned into the new loan. Doing so will mean paying interest for both cars, Reed cautioned. However, incentives could reduce the balance or even erase the negative equity, Reed wrote. His example: "If a person was $1,500 upside down on the trade-in car and wanted to buy a new car that had a $2,500 rebate, he or she could erase the negative equity and still have $1,000 for a down payment on the new car. Note, however, that cars with heavy incentives tend to have lower resale value for at least three years, according to Edmunds pricing analysts. This means you will be upside down for a longer period of time. In other words, it will take more time for this car to be available as a free-and-clear trade-in."

Originally published