Why You Should Pay Down Your Debt Before Financing a Car
It is always a good idea to pay down your debt. Surely, you have heard that mantra before. It is shouted from every personal finance rooftop on the internet. But why is it such a good idea, especially when you look at it in the light applying for a new car loan? There are many reasons you might not be immediately aware of, so here we go.
FICO Auto-Enhanced Score
When you apply for a car loan, any lender that you apply through will pull your FICO auto-enhanced credit score. This score looks at the five traditional categories that are used to build a credit score:
- Payment history (35 percent)
- Amounts owed (30 percent)
- Length of credit history (15 percent)
- Types of credit used (10 percent)
- New credit/recent credit lines (10 percent)
The auto-enhanced score takes a specific look at your past use of car loans and adds/subtracts points based on your repayment of those loans. This score is different than the basic score that you can buy from FICO and is only available to lenders. This score directly affects loan approval, the interest rate offered, and the length of the loan term.
Loan-to-Value Ratio (LTV)
The loan-to-value ratio of a vehicle is a critical factor in determining whether a loan will be approved or not. This is the value of the car compared to the total amount to be financed. If you trade-in a vehicle that still has an associated loan balance, the balance will be added to the new loan, increasing the LTV of your new car. Lenders normally deny loans that are more than 115 percent of the value of any vehicle.
Debt-to-Income Ratio (DTI)
DTI is your debt-to-income ratio. This is the total amount of money that you owe for normal debt repayment compared to your gross (before tax) income. When a new loan is being considered, a lender will look at your back-end ratio. The back-end ratio includes all of your recurring monthly expenses…loan payments, rent, utilities, insurance, etc. While each lender has a set amount that you can owe, including the loan being considered, the majority of them will deny loans that exceed a DTI of 45 percent.
Alright, the basic groundwork has been laid, so let’s look at why repaying a portion, if not all, of your current debt load is the best first step toward getting a car loan.
Back to FICO
Looking at the basics of how a FICO score is built, there are several areas that will be boosted if you pay down your debt. First is the amounts owed. This looks directly at the balances reported by your creditors. On your credit report, the initial loan/credit limit is listed as well as the current balance. Each minimum payment lowers that ratio and boosts your credit score a few points. The easiest way to make a major dent in that ratio is to attack credit card debt. If you make a lump sum payment on your lowest balance, your ratio will drop. Try this formula, add all of your credit limits together, then divide that by 10. That number will tell you how much you need to pay in order to drop your total amounts owed on credit card debt by ten percent. Why does that matter? Your score receives the biggest boost if the balances on credit cards are less than 30 percent of the limits on your cards. Dropping your balance by ten percent (the number you just came up with) a month is the quickest way to get to that point.
Addressing the LTV
The surest way to be denied for a car loan is to try borrowing too much money compared to its value. There are two ways to address that issue. First, you need to know the payoff for any vehicle that you intend to trade-in. Next, use kbb.com, nadaguides.com, or any similar site to see how much the average local trade value of your vehicle is. Preferably, the trade amount will be higher than your balance. At the very least, you want them to be equal. If there is a significant disparity, you may want to try one of two plans of attack.
The first is to delay buying another vehicle, but send additional money to your current lender each month. This will save you on total interest on the current loan and lowers the balance more quickly. Of course, that tactic assumes that you do not have a lump sum saved to use for the second plan of attack, which is offering a high down payment. If you can offer a higher down payment, you will immediately lower the LTV.
In order to know how much of a down payment that you will need, you will have to estimate the amount of the total purchase price plus any balance carry over. Compare that to the loan value of the vehicle you want. You can get the approximate loan value from the resources listed above or a local lender. Your target should be any LTV that is under 95 percent. This will keep your monthly payments down, lower your interest rate on the new loan, and give the lender an incentive to offer a longer loan term.
DTI, again
There are certain bills that you can not eliminate. After all, it is not reasonable to assume that you can pay off your mortgage just to get a better auto loan rate. Fortunately, lowering your credit card balances will also lower your monthly payments. If you have any small accounts owed, like medical bills or those Fingerhut and similar accounts, pay those off. You can always look for ways to lower your cable and cell phone bills as well. Every little bit helps encourage a lender to offer you a loan and makes the new payment more affordable.
Paying down your debt is a good idea whether you are considering a car loan or not. By paying attention to the areas mentioned in this post, you can lower the interest rate that you are offered, potentially allow you to be offered a longer loan term, and greatly improve your chances of getting the loan that you are seeking.
This post was co-written by personal finance experts and automotive enthusiasts J. Coffey and T. Brown. You can read more of their automotive-related work over at AutoFoundry.com.
I can’t add much about the loan process, but I can say that I’m glad I started saving for a new car years ago so I could pay cash now. We’ll be finalizing a purchase within the next couple of days and not having to even worry about loan options or paying interest has been a big comfort.
Matt, kudos on saving up the requisite cash to make your purchase outright! You’ll save a lot of money in the long run that way.
Definitely makes sense to pay down your debt before getting financing for a car. I am pretty certain I will have to finance my next car, at least in part, but I’m hoping for a good rate because of my credit score plus the fact that there are some really favorable auto loans out there today.
DC, I’ve thought about doing the same thing with my next purchase–financing perhaps 50% of the purchase, simply because I should be able to obtain a low rate and a paid-as-agreed loan would look good on my credit.
I agree that paying down debt really helps before financing a car loan. Personally I rather buy them cash vs financing but the wifey usually doesnt want a 20+ year old car. Having a great credit score and little debt makes buying and financing a car much easier.
The only time we’ve ever financed a car loan in the past (and hopefully in the future) was right after my wife’s bankruptcy and we had to go to one of those “everybody gets approved” places. The flip side of a dealership not running a credit check is that everyone gets the same high interest rate.
You’re spot-on, Edward. Those “buy here pay here” and “guaranteed approval” places might not pull your credit, but they balance this by charging exorbitant interest rates, often bordering on the upper APR limits set out in your state’s usury laws. Rates of 20%+ APR are not uncommon at such places (!)
Having gone through a car purchase with debt and one without, it’s so much easier to do the latter as opposed to the former. It can open up many other options if you’re financing and possibly get you a better rate.
No doubt, John. People forget what an important factor your debt-to-income ratio is in terms of approval and APR.
I wonder what kind of effect debt paid off through collections has on your credit, if any at all? My husband recently paid off debt that was in collections and we needed a new car after our old one completely died. The car place said he was basically a ghost and had no credit history. He was looking at an interest rate of 7%! Do they look at a co-signer’s DTI ratio? I have no income, lots of debt, yet maintain a good credit score and we got a 1.9% interest rate with me on as a co-signer.
Wow, Kasey! That is a great rate given your DTI. I *think* that when you have a cosigner, they will sort of pick and choose the best factors from each person on the application, if that make sense. So maybe they took his DTI and your credit, if that makes sense.
Yes, that would make sense. We were pleasantly surprised! Our credit union wouldn’t even give us that low of a rate !
Paying down debt is always good! We do have car loans even though most probably think we are dumb for doing that. However, if the interest rate is super low, then I am happy.
Michelle, I am with you. I grew up in a family that never financed their vehicles, but I am more open to it these days as long as the interest rate is low. I like the feeling of having that cash in my account, versus in a vehicle, and I’m willing to pay a little in interest to keep my cash in the bank 🙂
Great guest post to feature here! Anyway, I love that the auto FICO score breakdown was mentioned but, are there any resource we can double check that? To the best of my knowledge, FICO keeps their algorithms more secret than Google does! Anyway, great post! Thanks!
Thanks, Joshua! FICO actually outlines the breakdown pretty clearly here w/ pie charts and everything:
http://www.myfico.com/crediteducation/whatsinyourscore.aspx
Awesome Taylor, thanks for the resource!!!
I’d urge anyone who has debt and is considering financing a car to ask themselves why they are considering buying a car before paying off that debt! If it’s because their current car is on it’s last legs, then ok. But if they are just wanting a new car because it’s been a few years now since the last purchase and they want to “upgrade” then there is a fundamental disconnect going on. Paying off debt should always be a priority especially when considering taking on additional obligations (getting better terms on the new loan should not be the only impetus).
Nice! I have better thought: Once you pay down your debt, don’t finance ANYTHING, since you probably wanted to be out of debt in the first place. And for the love of all holy, DON’T finance a car!
Thanks for stopping by Tony. Why not finance a car? If you have good credit, then there are many opportunities to finance the car for 0% interest if you go with a new car. You can also get loans as low at 1.5% on a used car. I would rather keep my cash and go with a 0% finance then give it all away. This all depends on what you can get for an interest rate, but even if I went with a 1.5%, I would stick the money allocated for the car in my investment portfolio and then make money. There are cases now a days where financing a car makes more sense than paying cash.
I’m just learning that every little bit helps. I used to put off small bills like medical bills but now I try my best to keep up with them. I wish I would have paid off more debt before I bought my car but I was in a sticky situation because my old car which I had paid cash for had broke down. I had a choice of either paying $7,000 to fix it or financing. Looking back I wish I would have paid the money instead but being so young my parents influenced a lot of my decision making and they said its best to finance because I’d have a warranty and etc. So I went with their decision. But soon I’ll be moving to the city and I’m hoping to trade my car in for an electric scooter.
That is so true. Every little bit helps. Unfortunately, we can’t change what we did in the past, only what we do in the future.
I want to make sure that I do everything right when getting a loan for a new car. It makes sense that I would want to ensure that my other debts are paid off! Otherwise I could find myself in quite a lot of financial trouble!