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Watch Out for High Interest Rate and Sub-Prime Auto Loans

Article by R. Joseph Ritter, Jr. CFP® EA

An article was recently published reporting on a growing trend in sub-prime lending in the automobile industry. “Sub-prime” is a term used to describe loans that have a higher rate of default and are generally more risky.

Who may be offered sub-prime loans? Borrowers with a low credit score or negative credit history, an income that is too low to qualify for a traditional loan, not enough cash to make a significant down payment, and similar situations.

May I tell you a story?

When I finished graduate school, my wife and I with our infant son relocated to a new area for a new job and bought a house. At the time, we had two older vehicles, a pickup truck and a sedan. The following summer, we learned my wife was expecting our second child. Thinking the pickup truck would no longer work for our family, I made the decision to put it up for sale and look for another vehicle, preferably a four-door SUV.

One day I happened across an SUV that I liked, and it was priced around $3,000 to $3,500. We did not have the cash on hand to make the purchase. Instead, I had hoped that my pickup truck would sell, and we could use that cash to buy something else. Strike one.
Around the same time, we received in the mail checks that we could use to access the available limit on one of our credit cards. The dealership wouldn’t take the check, and none of the local banks would cash it. Strike two.

In a moment of exasperation, I wrote out a check on the credit card and deposited it into our bank account. The bank told me it would take some time to clear before the funds would be available. I resolved that if the SUV was still available when the funds cleared, my ship would have come in, and we would buy the SUV. If the SUV was not available, I would immediately repay the credit card. The SUV was available, I withdrew the cash, and promptly made my way to the dealership. Strike three.

On this website you will find a quote from S.M. Lockridge who said, “Experience is a good teacher. Unfortunately, she often charges too much in tuition.” My experience from battling very difficult financial circumstances is that if something is as hard to accomplish as buying the SUV with as many roadblocks as I encountered, the last thing I should be doing is forcing it to work.

I blew through three red flags

  • My truck hadn’t sold.
  • I didn’t have the money.
  • The bank said no.

We were clearly not in a financial position to do what I did. We did not have the means to pay for the SUV, and tapping the credit card for what I thought would be a short amount of time didn’t work the way I thought.

It’s true that I felt I was entitled and felt I should have the SUV to accommodate our growing family. If everything went according to my plan, we would have been ok financially.

Here’s the rest of the story. Within a few months of buying the SUV, I learned that my job was coming to an end. I tried unsuccessfully to find a new job in the area, and we wound up relocating for the second time in less than two years. Our problem was that the house was slow in selling, and moving is expensive. My new income was a little better but not enough to keep up with all the demands on our finances in such a short amount of time.

My pickup truck did sell, but it sure would have come in handy during our move. And there was nothing wrong with it mechanically. In fact, it was one of the best vehicles I have ever owned. The SUV on the other hand turned out to be full of problems. We did eventually pay off the credit card, but it sure made life a whole lot more difficult.

Two of the stories in the article on sub-prime lending resonated with me, which is why this article was written. One gentleman bought a used vehicle on a high interest rate, sub-prime loan offered through a new car dealership. To make the downpayment, he traded a shotgun because he did not have enough cash. He later went through a divorce and lost his job.

Another couple bought two used vehicles from a new car dealership, both with high interest rate, sub-prime loans, and had car payments totaling $900 for both vehicles. The wife later lost her job, and the payments were too much for them to afford.

In both cases, they wound up filing for bankruptcy.

Experience is a good teacher, but her tuition is high. Our fees are very affordable and worth a try before you make the kinds of mistakes covered in this article – mistakes that can cost you many thousands of dollars and years of financial bondage and stress.

A quick rule of thumb is that combined payments on short-term and unsecured debt (credit cards, student loans, car loans, etc.) should be no more than a total of 8% of your income. If you make $40,000, that’s about $267 per month. Using this scenario, the couple making car payments of $900 should have had an income of $135,000.

I know what you’re thinking. “Guess what I could do with $135,000!?!” I don’t know what this couple’s actual income was, but $135,000 is probably unrealistic.

When you hear me say, “What are your priorities,” my point is to help frame your thinking toward the most important things you need to get done and where you want to be in 6 months, 1 year and 5 years. I do not believe anyone has in their list of priorities going through bankruptcy, divorce from financial stress, or never being able to enjoy life because they are drowning in debt.

You don’t have to be another financial statistic. Let our experience work for you.

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