Almost anyone gets a car loan approval with a high credit card balance. Dealers are eager to move iron, and lenders can find creative ways to fund almost anyone – regardless of their qualifications.
You just may not obtain the best terms or interest rate.
Paying off your high credit card debt before buying an automobile can help you qualify for a better vehicle with contract terms that are more favorable and interest rates that much lower.
However, you have to wait while you reduce your amount outstanding.
Alternatively, you can buy the automobile right away. Then your debt levels will even higher, and you will have to weigh the pros and cons of which obligation to pay down first.
Pay Off Credit Card Debt or Car Loan First
If you decide to obtain a car loan with high credit card balances, the next question becomes which you pay off first. Once again, there is no right or wrong answer to this question.
The most popular approach (comparing car loan interest versus credit card interest) may not be the ideal solution for everyone. Sometimes, you have to look beyond the obvious to decide which debt to retire most aggressively.
Request an unsecured debt consolidation loan. Use the borrowed funding to retire existing credit card obligations. This approach has several possible benefits.
- Lower monthly payments by extending the repayment terms
- Accumulate enough cash to make a down payment
Paying Off Credit Card First
The first advantage of paying off your high credit card debt before your car loan is the direct interest savings. For most borrowers, unsecured revolving balances have higher interest rates than a secured installment loan. Lenders price money more expensively when they cannot easily repossess collateral.
The second advantage of paying down credit card balances first is that you improve your risk ratings. The equations calculate two utilization ratios, but one is more important than the other.
- Revolving unsecured ratio
- Installment secured ratio
The revolving utilization ratio for unsecured debt is the most important ratio in the in the equations. By prioritizing this key ratio, you position yourself to pay lower interest rates indirectly on bigger purchases such as a home.
The biggest disadvantage of paying down credit card balances first is that you might lose your automobile. If you lose your car, you may not be able to commute to work. If you cannot commute to work, you may lose your job. If you lose your job, your entire financial house-of-cards comes tumbling down.
You may encounter financial difficulties such as a surprise repair expenses, or a sudden drop in income. Banks can decrease your credit card limit at any time. You may not be able to finance your lifestyle temporarily using plastic. If you then fall behind on car payments, the lender can repossess the vehicle.
Paying Off Auto Loan First
The primary benefit of paying off your auto loan before your high credit card balance is that you own the vehicle title free and clear. The bank is no longer a threat to repossess the transportation you need to commute to work and earn an income.
Nobody is immune from economic shocks that cause people to fall behind on payments. Once you own the title, the machine is yours to keep – no matter what happens to your financial situation.
The secondary benefit of paying off your auto loan first is that you may improve your debt to income ratio (DTI) more – depending on your proximity to the end of the contract term. This becomes very important if you want to buy a house, refinance your mortgage, or buy another vehicle.
Eliminating one monthly payment improves your DTI. Eliminating the largest monthly payments helps the most. This often means paying off your car loan first, especially for consumers nearing the end of the contract term.
- The credit card minimum payment calculation results in a rolling amount – 1 % of the revolving balance, plus fees and interest for the month, or approximately 2%. A two percent minimum monthly payment on a $5,000 balance is $100.
- A car loan is an installment contract with fixed monthly payment amounts and a fixed number of periodic payments. This chart illustrates $5,000 principal at 10% interest rates.
|Remaining Term||Car Payment|
As you can see, a consumer owing $5,000 on both a car loan and a credit card can free up far more cash flow by paying off the installment contract first – if he or she is near the end of the term.
The primary drawback to paying down your car loan first is that you do not realize the benefits until you have the title to the vehicle in your hand. Up until that time, you limit your financial flexibility. The average term is 5 years, so you have to be very aggressive to make this approach work in your favor.
A car loan is a closed-ended installment contract, whereas a credit card is an open-ended revolving account. This means that your car payment remains fixed, and is due in full the next month, no matter how much extra you paid in the past. With a revolving account, the minimum monthly payment due next month adjusts to the outstanding balance.
Paying down the principal on an auto note only shortens the term. Here are some possible negative consequences you may feel until the amount owed reaches zero.
- A 30-day late payment will stain your consumer report, even if you doubled up on previous payments. This will hurt your ratings for 7 years.
- You cannot tap into the equity in the vehicle without refinancing. If you encounter a temporary cash shortage, you are stuck. Having a credit card with sufficient open-to-buy ( the difference between the limit and balance owed) provides better financial flexibility.
Paying Off Credit Card Debt before Buying Car
The first issue to explore is paying off your high credit card balance before buying a car. Like many finance-related questions, there is no right or wrong answer. The approach presents pros and cons. You will have to weigh the two and find the best approach for your situation.
Better Credit Rating
The primary advantage of paying down high credit card debt before purchasing an automobile is that your rating should improve. A better rating translates into a greater approval odds, and lower interest rates. Lower interest rates mean a smaller monthly payment on your new vehicle, which gives you the opportunity to begin building an emergency fund to shore up your finances.
The amount of money you owe makes up 30% of your credit rating. Revolving balances carry a very heavy weight in the rating equations, and the utilization ratio is a very significant factor. You calculate the revolving utilization ratio by dividing total revolving balances into the cumulative limit of your revolving accounts – which frequently include credit cards and home equity lines of credit.
It is best to keep your revolving utilization ratio below 30% in order to optimize your rating and enhance your eligibility. You also save a significant amount of money by avoiding the more expensive interest charges associated with unsecured revolving debt.
Lower Down Payment
The disadvantage of paying down high credit card balances before applying for a car loan is that you then have fewer resources to make a significant down payment. The size of your down payment relative to the sticker price of the vehicle is an important underwriting criterion.
The larger your down payment is the better your chances of obtaining an approval at an affordable interest rate. Every dollar used to reduce your credit card revolving balance is a dollar you do not have to save towards the down payment.
There is a tradeoff between the two competing objectives. Speak with the finance and insurance person at the dealer for specific guidance on your personal situation – well in advance of submitting an application – or falling in love with an auto you cannot afford.
If you are trading in your old clunker, the dealer will count the value as part of the down payment. Keep in mind that the dealership will value the trade-in using a wholesale price. You may do better for yourself by selling the vehicle privately at retail.