A Lot of Debt, Some Cash and a New Car

by Gary Foreman

I need some advice. We are buying a new car and have a lot of credit card debt. Should we pay cash for the car and own it free and clear? Or pay down some of the debt and finance half of the car purchase?

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 interest payments.

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 yesterday's pizza.

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 its value much quicker than a used card does.

For instance, according to KelleyBlueBook.com, a new Ford Taurus will lose approximately 50% of its 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

Gary Foreman is a former financial planner and purchasing manager who founded The Dollar Stretcher.com website and newsletters in 1996. He's been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money, Credit.com and CreditCards.com. Gary shares his philosophy of money here. You can follow Gary on Twitter. Gary is also available for audio, video or print interviews. For more info see his media page.

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