If you, like most of us, need to make your income go further, it’s helpful to start by looking critically at your monthly budget, starting with your biggest expenditures. Transportation costs are the second biggest category of expenses for the average American, second only to the cost of housing. We spend over $9,500 on transportation in the average year, or almost $800 per month. These transportation costs, of course, include items like gasoline and repairs, but the largest portion of our transportation expenses by far is the cost to purchase our vehicles.
Because most new vehicles are purchased with loans, taking a second look into whether you can lower your car payment is a very smart way to improve your monthly budget. An auto loan calculator can also help you visualize the effect each factor of the loan will have on your monthly payment.
Option 1: Refinance to lower your car payment with a lower interest rate
If you have an existing car loan, the quickest way to lower your car payments is to refinance the loan to a better one. On average, you can reduce your interest rate by 2.4%. The interest rate you are paying, expressed as the Annual Percentage Rate or APR, is another way of describing how much a loan costs you. Why don’t more of us look into refinancing our car loans? The answer is hiding in plain sight. Most of us do not know that we can refinance our car loans.
Although 2.4% sounds like a small number, it could add up to over $2,200 in savings over the life of your new loan. That’s nothing to sneeze at. The average car loan is about $32,000, and the average term is about 68 months (or over 5½ years). Let’s assume you refinance five months after you bought your car. A 2.4% reduction in your interest rate would lower your car payment by over $30 per month. Multiply $30 by 64 months, and you save a total of $2,304. Now you can use that $2,304 to pay off some high cost credit card debt or take a vacation. Congrats!
Option 2: Refinance to lower your car payment by extending your term
For car loan terms, a shorter loan term means less interest paid over the life of a loan. However, lengthening your loan term can reduce your car payment every month, sometimes significantly. The car loan market is massive, with over one trillion dollars in loans outstanding. That means every kind of lender and investor is involved in the auto loan market. As a result, the variety of car loan terms available may surprise you. Loan terms extend all the way out to 84 months and beyond at the extreme.
Let’s take a typical example. Assume you have a $25,000 principal loan balance and 50 months remaining on your car loan at a 5% interest rate. If you could refinance to a 60 month term at the same 5% interest rate, your monthly payment would drop from about $550 to $470. That’s $80 per month freed up in your budget. It is true that you will spend more in interest expense over the life of your new 60 month term, but there are times when that can make sense based on your other budgetary priorities.
Option 3: For your next car purchase, buy used to lower your monthly payment by $136
Most of us have heard that the moment you drive your shiny new car off the lot, it loses 10 to 20% of its value. Nothing much has changed except that now you’re the owner of a used car. While the rapid depreciation in new car values is annoying to new car owners, it is good news for used car shoppers. Cars are now more reliable and last longer than ever before. All of this means that used cars are better options for many of us than they’ve ever been. And here’s the best part. The average monthly payment on a used car is about $400, while the average monthly payment on a new car is roughly $536. That $136 difference can help a lot.
Option 4: Lower your car payment by trading down
Maybe you did buy too much car. That 8-seater is a pain to park. The leather seats on the luxury package minivan are not impressing your kids or their friends. You could sell your car and buy a more economical model. Making this option all the more interesting, and convenient, is the proliferation of new online services that will buy your used car, like Carvana. By entering some basic information about your car on one of these sites, you can quickly get a firm offer. If you agree, these companies will pick your car up at your home and bring a check with them. You can use that check to pay off your old car loan, and buy a smaller, less expensive vehicle.
Some background: Here’s why your car loan payment is too high to begin with
If you’re like most Americans, you were excited to buy a new car, to breathe in the new car smell (or at least stop smelling your old car). You asked your friends about how they liked their cars, you did 15 hours of online research, researching reliability and gas mileage and so on. You checked around with a number of car dealerships to see who had the right color and who would give you the best price.
Here’s the problem: you probably didn’t shop for a car loan. Over 70% of us get our car loans when we’re “signing the paperwork” in the back office of the car dealership. While this is convenient, it is a terrible idea. Why? Because the car dealer probably does not have your best interest in mind when arranging a loan for you.
The problem is getting worse. Car dealership profitability has shifted dramatically over the past 10 years. Car dealers used to make most of their money the way you would expect. They buy a car from the Ford or Toyota factory, and sell that car to you for a higher price. Simple and old fashioned. But over the last 10 years, the internet has created much greater price competition among dealers for your business. The result is that we as consumers do much better and car dealers earn less when they sell you a car. That’s good for you.
The flipside? You now pay a larger markup to arrange your loan than you do to buy your new car. As resourceful businesspeople, car dealers have made up for declining earnings on the car sale where most of us don’t look: our car loans. Guess how much car dealers make for arranging your loan? $1,788 for 2018, according to the Outside Financial Auto Loan Markup Index. That’s a 70% increase from the $1,046 in markup we paid in 2010.
Look on the bright side: it’s not too late. You could have saved $1,000 you didn’t know you were spending, if you’d shopped for a car loan before you went to the dealership. But what about if you already bought your car with a loan arranged by the dealer? The average borrower saves over 2% on interest and over $50 a month by refinancing to a better loan. It’s quick and easy to figure out how much you can save (and it doesn’t affect your credit).
[Disclosure: Jon Friedland is the founder of Outside Financial and an Investopedia contributor. Investopedia does not or has never received compensation from Outside Financial]