Personal Finance Tip of the Week, By Financial Fundamentals, LLC of Watertown

If you need to borrow to buy a car, take a few steps to ensure that your loan stays “above-water,” where your car is always worth more than the loan. This will give you more financial flexibility down the road.

The opposite situation, an “under-water” car loan, occurs when your car is worth less than the loan. This can cause multiple financial headaches:

• Instead of getting cash back when you sell your car and close out the loan, you will owe money to the lender. This will make it more difficult for you to make a meaningful down payment on your next car, which may cause you to sink under-water on your next loan too.
• You won’t be able to refinance into a lower rate loan if your credit score improves. Instead, you will be locked into your original higher rate loan.
• You may not have the financial flexibility to get out from under the loan if you face a financial emergency. This can lead to late payments and, in some cases, repossession.

All of these headaches will hold you back financially, but the last one - a lack of financial flexibility in an emergency - can be especially devastating to your financial goals. Your credit score may decline significantly, and you may need to redirect savings from other goals to fix the situation. These effects can derail your goals for years.

Luckily, with a little advance planning, you can avoid these headaches and ensure that your car loan always remains above-water:

• Put at least 20% down when you buy the car. Borrow no more than 80% of the car’s price.
• Choose a loan term of 4 years or less. Avoid loans with terms of 5 or 6 years or longer.
• Buy a car that holds its value (i.e., depreciates slowly). Consumer Reports, KBB, and NADA Guides offer statistics on the depreciation rates of different car models.
• Keep the car in good condition so that it will fetch a high resale value when you sell it. Put a little extra maintenance money in your budget to care for the car.

With these steps, you will pay down the loan faster than the car depreciates. This will ensure that the car is always worth more than the loan balance and the loan won’t sink under-water.

If a 20% down payment and 4 year loan term are out of reach for you today, try to postpone your car purchase until you can afford it. Establish a financial goal to prepare for your purchase, and fund the goal with savings from your monthly budget and your annual tax refund.

It may take a little while to accomplish the goal, but your financial future will benefit as a result.

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Stephen Barkhuff, CFP(R), CFA, MBA is the founder and president of Financial Fundamentals, LLC, based in Watertown, MA. Financial Fundamentals helps couples and singles with modest incomes take control of their financial future. You can reach him at mailto:SBarkhuff@FFundamentals.com.