NEW YORK (MainStreet) — Over the past three years, Jeremiah Kersey, an IT help desk supervisor in Etowah, Tenn., and his wife have replaced one car at a time on three different occasions and rolled the auto loan over each time.
Since his bank allowed Kersey to put both of their cars on the same loan the first time and the couple was able to obtain competitive interest rates of an average of 4%, it made sense to them to finance their vehicles in this manner since the value of cars exceeded the amount of the loan.
“In this situation I would recommend it,” he said. “If the bank offered a lower interest rate based on the principal of two vehicles, I would continue to roll that loan over rather than opening a second loan.”
But take caution: car owners who roll over their existing loan into a new one to finance the purchase of another car often are facing a situation where the car is worth less than what they owe, said Jim Triggs, a senior vice president of counseling and support of Money Management International, a Sugar Land, Texas-based non-profit debt counseling organization.
“You will usually be upside down on your new car, which means you will owe well more than it’s worth,” he said.
Some owners find themselves with higher monthly payments, straining their household budget and extending the terms of their loan. The longer payment terms results in consumers paying higher amounts of interest, delaying the payoff of the principal.
This nimble rollover method allows some consumers to make purchasing another car an easier reality, but the drawback is that someone who chooses a five-year loan, for example, is still paying on the first car for a total of eight to ten years or even more, Triggs said.
To boot, being upside down on the new car can trigger a requirement to purchase “gap insurance,” which could cost an additional $500 or more.
If you want to avoid this situation, one method is to negotiate aggressively with the dealer on the trade-in price for your car, Triggs said.
“Let the dealer know that paying off your old loan at the total amount that you owe is a term of the new deal, or you will not buy the new car,” Triggs said.
Selling the car privately yourself means you could net a higher price than just trading it in at a dealership, he advises.
“As a last resort, if you have to get a new car, look for incentive deals like rebates which will offset the difference in what you owe versus what they will pay,” Triggs said.
Rolling one installment loan such as an auto loan to another will most likely not impact your credit score “greatly,” he said, but there are potential implications.
Of course, by increasing the amount you owe overall and your monthly payment, this could raise your debt-to-income ratio. A high debt-to-income ratio is a red flag to other potential lenders such as a credit card issuer or mortgage company.
While many auto dealers claim they can pay off your current car loan for another loan, “it doesn't mean it is best for your bottom line,” said Bruce McClary, spokesperson for the National Foundation for Credit Counseling, a Washington, D.C-based nonprofit.
“The value of a new car depreciates as soon as it leaves the lot, which doesn't bode well for those who financed their new set of wheels up to or beyond the appraised value,” he said. “Apart from being instantly upside down on the financing, it is also possible that the dealer might have undercut the trade-in value of the old car to increase their profit margin.”
Opting for this method to finance a car has another caveat – the balance of the previous car loan may not be paid off quickly. Some reports have suggested that dealers don’t always ensure the loans are paid off on time and exceed 30 days, McClary said. By delaying the payment, car buyers can be at risk of having their credit score lowered because a "past due" is noted on their credit report. In addition, the driver could contend with having to pay late fees.
Since Kersey was never upside down on any of his car loans, he said he also did not notice a change in his credit score. When his wife and he decided to get a second car so they did not have to share the same one, they were able to find a bank that offered lower rates. The Kerseys wound up going from a 6.7% to a 4.0% loan because they agreed to roll the existing loan into the new one.
The couple chose to replace one car 11 months ago, and they were faced with choosing a new loan or refinancing again. The fees for rolling over the existing loan were the same as opening a new one at 4%.
“We had a son at this point, so the lower monthly payment was a big positive,” he said. “The bank ended up lowering our interest rate to 3.0% due to a separate issue, so we were saving money at that point.”
Their last rollover occurred six months ago when they needed to buy a SUV to fit both their children and their rear facing car seats, increasing the interest rate to 3.64%.
“My situation may be slightly different than most people,” Kersey said. “All of the cars I traded were worth their percentage of the loan balance. So, if they were on separate loans it would have resulted in a payoff and a new loan.”
While rolling over an old loan often does not cost anything out of pocket, be prepared for shell out more money each month, said Philip Reed, a senior consumer advice editor for Edmunds.com, the Santa Monica, Calif.-based car shopping website company.
“Rolling over a loan is a convenient way to buy a new car, but your monthly payments will be higher, because you will not only be paying interest on the new loan, but also on the balance of what you owe on the previous car,” he said.