Carrie asks a good question. And, she has plenty of company.
Studies show that the average family now has over $18,000 in debts (excluding
their mortgage). At the same time millions of those families will be car
shopping this year.
What should Carrie do? Let's start by comparing the cost of the
two loans. We're going to have to make some assumptions about Carrie's credit
rating and the interest rates charged. To get more precise she can do the
calculations using her actual rates. For illustration, we're going to assume
that she has $10,000 available.
If she uses the money to pay for the car she'll have $10,000
more in credit card debt. At a rate of 14%, it will cost $1,400 per year in
A car loan will be a lower cost loan. About 8% lower than the
credit card rate. It will run about 6%. That means she'll pay $600 per year in
interest payments. So using the money to pay off credit card debt will save her
$800 per year.
Why is that? The auto loan is a 'secured' loan. In other words,
the car guarantees the loan. If Carrie doesn't make her car payment the lender
can repossess the car. That's not true with a credit card. They can't repossess
There's another advantage to using the money to pay down credit
card debt. It could improve Carrie's credit score. The amount of money that you
owe makes up 30% of your credit score. The only thing more important (35%) is
how good you are about paying your bills on time.
And, it's not just how much Carrie owes. How close she is to the
account maximum is considered, too. So, by paying down the accounts that are the
closest to being maxed out, she'll not only be spending less each month on
interest, but she could lower the rate that she'll pay on the auto loan.
While she's thinking of her credit score, Carrie should also
check for errors in her report. Studies have shown that about one in four have
an error large enough to affect the rate you pay to borrow money.
When she's car shopping Carrie shouldn't let every dealer access
her credit file. Too many queries over a short period of time will actually
reduce her credit score.
In fact, if Carrie is going to make car payments, she'd be wise
to line up her financing before she goes car shopping. Her bank or credit union
is likely to give her a better rate than a dealer.
It's hard to be sure whether Carrie really means to buy a 'new'
car or simply a 'newer' car. Hopefully she'll consider the newer car. The reason
is simple. A new car loses it's value much quicker than a used card does.
For instance, according to KelleyBlueBook.com, a new Ford Taurus
will lose approximately 50% of it's value in the first three years. Depending on
options, that's roughly $10,000. But, that same Taurus will lose a little less
than $4,000 from years four through six. Sure Carrie would be driving a little
older car. But she'll save $2,000 per year for the sacrifice.
Another option would be for Carrie to consider delaying the car
purchase for a year. Let's look at how much cash that could mean to her. By
applying $10,000 to reducing credit card debt she'll save $1,400 in interest
during the year assuming a rate of 14%.
Sure she might need to put a little of that money into repairs.
But, she'll still be richer when she does go car shopping a year from now.
As a general rule, if you have 'a lot' of credit card debt the
best thing you can do is to pay it off first. It's usually the most expensive
debt. And carrying large card balances can come back to haunt you in a variety
of ways. Especially after an auto purchase has taken most of your cash reserves.
Gary Foreman is a former
financial planner who currently edits The Dollar Stretcher website
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