Dangers of Using Student Loans to Buy a Car
When the federal government issued the first student loans in 1958, the message was simple: The money was to be used for educational purposes, meaning tuition, books, fees, supplies, and living expenses such as room and board.
There is no mention of using the money to buy a car.
The purpose of student loans is to equip you with lifelong knowledge. The purpose of the car is to equip you with pockets full of expenses that start before you even get the keys.
So, before you stop by student financial services on your way to the dealership, take a moment to read why buying a car with a student loan is a bad idea. Hindsight is always 20/20, and you don’t want to be stuck paying the price years down the road for a bad decision you made in college.
Can you use a student loan to buy a car?
Technically, when you take out a student loan, you agree that the money will be used for educational expenses. You can make the case that the only way to get to school is by car, and in reality, once the student loan money is in your bank account there is no oversight.
You can cash the check and go to the car lot or somewhere else and spend the money.
A better question is, “Should you use student loans to buy a car?”
It may seem like a good idea at the time, but there are three reasons why buying a car with student loans will cost you more than you bargained for.
1. Interest rates
Student loans interest rates are higher than the average car loan rate. The average five-year auto loan interest rate in 2018 is 4.21%. Undergraduate student loans rates were set at 5.05% and graduate loan rates in 2018 are 6.6%. Direct Plus Loan is 7.6%.
2. Loan Terms
The average loan tenure for a car – new or used – in 2018 was 68 months. That means you’re paying for 5-6 years, although it could be less if you can afford the higher monthly payments. You should try to pay off the car as quickly as possible before it loses most of its value.
The standard repayment plan for student loans is 10 years and that’s if you can afford it right out of school. Many graduates opt for income-based repayment plans that can extend the loan tenure to 20-25 years. You don’t want to be in a situation where you’re still paying for the car 10-20 years after buying it and maybe not even driving it anymore.
A brand new car will depreciate 20% in the first year, and all cars depreciate about 10% per year after that.
Example of Auto Loan – Honda Accord
value of the year
New (2019) $27,075
Kelly Blue Book
Let’s say you bought a 10-year-old Honda Accord for $7,645 — Kelly Blue Book value — with student loans money at 5.05% interest. After 10 years of paying off the student loans with the standard repayment plan, you will have paid a total of $9,753 for an asset that is now 20 years old (if you still own the car) and worth only $2,641. That’s a loss of $7,112.
Options for buying a car with a student loans
1. Public transport
You might not want to see this as the No. 1 suggestion, but AAA estimates that the average sedan costs $8,469 a year to own in 2018. Insurance, maintenance, gas and depreciation all factor into the true cost of car ownership. Take a moment and think if you really need a car to get around and what? Most colleges are walkable once you get on campus. Almost all have good bus services to get students around campus and to nearby apartments. If you need transportation home, you can also hire buses from Greyhound and Megabus. Not always convenient, but much cheaper than owning a car. Think before you take on debt you will regret in the end.
2. Bicycle or scooter
The college campus is very bicycle and scooter friendly. You never have to worry about parking or adding to student debt. You can get a good second-hand scooter for less than $1,000 or a bike for a few hundred dollars. If you need to go across the city, you can connect your bike to a bus route to get there. Hang it on the bus rack and ride the bike from the stop to your final destination.
3. Save cash in summer
If you need a car, avoid financing it with student loans at all costs. Summer and weekend jobs are your best option during the semester. Save money and buy a cheap used car. Check with local mechanics for a good deal. Often, they fix up unwanted cars themselves and sell them cheaply. Family and friends are often good sources for finding a deal from someone willing to help a college student.
How to get the best auto loan as a student
Getting an auto loan as a student can be a daunting task. Lenders want to see a credit history that includes a low debt-to-income ratio (DTI) and a good credit score.
Most college students with loans have low incomes and borrow significant amounts to pay for tuition. On top of that, their credit history is relatively new and probably not as diverse as lenders would like to see.
But if you have a scholarship that takes care of your tuition and a steady income, it’s worth giving it a shot. You can build a positive credit history by getting a credit card with a low spending limit ($1,000 or less), use it for a short period of time, and pay it off at the end of each month. Also, pay your rent and utility bills on time and have them report that information to the credit agencies.
It will help you establish a solid credit score and from there the possibilities of getting a good auto loan will really open up.
Your credit score is a powerful bargaining tool
Request a free copy of your credit report from TransUnion, Experian or Equifax to see how you stack up. You’ll want your credit score above 700 and a debt-to-income ratio below 40% to get a chance at a good interest rate.
Take your credit report with you to a bank or credit union and see if you can get pre-approved for a loan. Adding a cosigner can help college borrowers overcome some credit history issues.
Don’t fall victim to a buy here, pay here dealership
Consumers who see a “buy here, pay here” used car lot should see it as a warning sign, not an invitation to a good deal. You may get approved on the spot, but look very closely at the terms. The average interest rate from these dealers is 19%.
Buy here, pay here owners have no problem approving high-risk borrowers. They will saddle them with extremely high interest rates with monthly payments they know the borrower cannot afford. When the borrower misses a payment, the owner repossesses the car and sells it to another customer.
Should I use my student loan to rent a car?
In most cases, any financial advisor will tell you that leasing a car is a bad idea. One of the few situations where it makes sense is if your only option is to finance the car with a student loans.
You don’t want to take out money (student loans) to pay off more borrowed money (auto loans). You will pay interest on front end and back end.
Leasing a car with a student loans can work if you have cash flow issues. Since you don’t have the income to afford the monthly payments on a traditional car loan, the issue comes down to paying cash for the car or taking out a student loans to lease the car.
Calculate how much debt you would add by purchasing a car. Then calculate the cost of leasing (fees included). Don’t forget to factor in depreciation into the resell value. Even then, you might find that buying a car and reselling it after college beats the cost of leasing.
Bottom line: Never use student loans to buy a car
Getting a student loans is a simple and familiar process for most students, and if you’re shelling out thousands of dollars to finance your education, adding another few thousand may seem like another drop in the bucket.
But consider this: About half of college graduates who have student loans are in repayment plans that take more than 10 years and as long as 25 years. You can still make payments on your college car while you shop for your child’s first set of wheels.