Auto Loan: New Car vs Old Pros and Cons

There are over 25 million auto loans every year in the United States, with the majority of drivers using finance to pay for new and used vehicles. Car loans are some of the most common secured loans in the country and for many Americans, a car is the second most expensive purchase they will make […]

Auto Loan: New Car vs Old Pros and Cons is a post from Pocket Your Dollars.

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What Is Gap Insurance, and What Does It Cover?

When purchasing or leasing a new car, you have several insurance coverage options. When selecting coverage, you will likely know if you want to have collision coverage or not, but will you know what gap insurance and whether to select that … Continue reading →

The post What Is Gap Insurance, and What Does It Cover? appeared first on SmartAsset Blog.

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Should You Pay Down PMI or High-Interest Debt First?

Money Girl listener Danielle M. says:

I’ve been listening to your podcast for about five years now since I graduated from college. I greatly appreciate the tips and guidance you give to the community as a whole. Thank you for giving me the confidence and knowledge to build a solid financial foundation.

I recently purchased a home, which includes a PMI payment. I also have student loans and a small car loan. We have extra money every month to put toward our loans. I understand it’s best to pay down debt in order of the highest interest rate first. I’m wondering how to evaluate my mortgage since the interest rate doesn’t include PMI payments. Should I pay down my mortgage until the PMI is gone, or is it better to focus on my higher-rate student loans first?

Thanks for your great question, Danielle! Understanding where to put your extra money each month is incredibly important. In this post, I’ll explain what PMI is, the rules for eliminating it, and how to know when it should be your top financial priority.

What is Private Mortgage Insurance (PMI)?

If you take out a mortgage to buy a home or refinance an existing home loan, the last thing you want to hear is that you have to pay an additional charge, called private mortgage insurance or PMI. You might feel even worse when you find out that this insurance protects the lender, not you!

Borrowers have to shell out for PMI when they get a conventional mortgage but can’t put at least 20% down. The amount you borrow to buy a home is called the loan-to-value (LTV) ratio. For example, if you borrow $180,000 to buy a home valued at $200,000, you have a 90% LTV ($180,000 / $200,000 = 0.90)

Borrowers have to shell out for PMI when they get a conventional mortgage but can’t put at least 20% down.

When your LTV on a home mortgage is higher than 80%, lenders consider you to be a bigger risk than if you borrowed less. The lender mitigates that risk by requiring you to purchase PMI. The policy would cover a portion of their loss if you didn’t pay your mortgage and foreclosure proceeds don’t cover your outstanding loan balance.

However, there's a bright side to paying PMI. It makes it possible for many borrowers who can’t afford to put 20% down to buy a home. And it can be eliminated at certain LTV thresholds, which we’ll cover.  

What’s the cost of PMI?

The cost of PMI varies depending on many factors. These include the type of mortgage you get, how much you put down, where the property is located, your credit, your loan term, and how lenders structure your PMI fee. In general, there are three ways lenders charge PMI:

  1. Monthly payments – which get added to your monthly mortgage payments. The premium could range from 0.2% to 1.5% of the balance on your loan each year. The annual cost is typically divided into 12 premiums and added to your monthly payments.
     
  2. Lump-sum payment – is a one-time premium that you pay upfront at closing. You may also pay both upfront and monthly premiums.
     
  3. Higher interest rate – a lender may charge a higher interest rate instead of itemizing separate PMI charges.

Monthly payments are the most common way that borrowers pay for PMI. Let’s say you get a 30-year, fixed-rate mortgage for $180,000 to buy a home valued at $200,000. With a 90% LTV and good credit, your PMI could cost about $100 per month.

Paying monthly PMI gives you the most transparency about the charge. It gets itemized on your mortgage statement, so you know exactly how much you're paying. And more importantly, you can see when it finally gets eliminated, which we'll cover next.

If your lender offers more than one way to pay PMI, ask for a detailed pricing comparison so you can weigh the pros and cons.

If you make a lump-sum PMI payment, it could turn out to cost more or less than the other options, depending on whether you choose to pay off your mortgage ahead of schedule. If you sell your home after just a few years or pay off your mortgage early, you don't get a return of any PMI premium.

Since mortgage interest is tax-deductible, the option to pay a higher interest rate instead of separate PMI payments could cost less on an after-tax basis. Also, PMI is currently a tax-deductible expense, although there have been periods when it wasn’t. At the end of the year, lenders send out Form 1098, which lists how much PMI and mortgage interest you paid during the year so that you can claim it on your tax return.

However, you can only claim these deductions if you itemize them using Schedule A. When your total itemized deductions are less than the standard deduction for your tax filing status, you'll save money claiming the standard deduction instead.

As you can see, knowing which option is best for paying PMI can be a bit complicated. If your lender offers more than one way to pay it, ask for a detailed pricing comparison so you can weigh the pros and cons and consider which option may cost less.

Rules for eliminating Private Mortgage Insurance

Now that you understand why and how lenders charge PMI, let’s review the rules for getting rid of it. That will help you know how high a priority it should be.

You should receive an annual notice from your mortgage lender that reminds you about your options to have PMI eliminated under certain conditions. Here are the ways you can get rid of monthly PMI payments.

When your mortgage balance reaches 78% of the original value of the property, PMI must automatically be canceled.

Request cancelation. After you pay down your mortgage balance to 80% of the original value of your home, you can ask for PMI to be canceled. Your original value can be either the price you paid for your home or its appraised value when you bought it (or refinanced it), whichever is less.

Your lender will require you to pay for a property appraisal to verify that your home’s value is the same or higher than when you purchased it. The appraisal fee could range from $300 to $1,000, depending on the size and location of your home.

Automatic termination. When your mortgage balance reaches 78% of the original value of the property, PMI must automatically be canceled. In this case, you don’t have to request it or pay for an appraisal.

Midpoint termination. When your mortgage balance reaches its midpoint, PMI must be automatically canceled. For example, if you have a 30-year mortgage, your lender must cancel your PMI after 15 years.

But keep an eye out for situations that might allow you to cancel PMI early, like when your home value appreciates due to market conditions. When your home value goes up, it lowers your LTV. Likewise, if you make additional mortgage payments that reduce your principal loan balance, it lowers your LTV. The faster you get to the 78% threshold, the sooner you can request a PMI cancellation.

Keep an eye out for situations that might allow you to cancel PMI early, like when your home value appreciates due to market conditions.

However, be aware that your lender can deny your request for PMI cancelation in certain situations, such as if you’ve made late payments. You must get current on any outstanding payments to have PMI canceled either as a request or automatically. Also, don’t forget that taking out a home equity loan or line of credit increases your LTV.

When should eliminating PMI be a financial priority?

Now that you understand when you must pay PMI and when you can eliminate it, let’s turn to Danielle’s question. She's considering whether to send extra money to her mortgage and get closer to canceling PMI or if it's better to pay off her student loan or car loan faster.

First, I’d recommend that Danielle zoom out and look at any other top financial priorities. She didn’t mention if she’s regularly contributing to a retirement account or has emergency savings. If she doesn’t have a healthy emergency fund, or she isn’t investing a minimum of 10% to 15% of her gross income for retirement, that’s where her extra money should go first.

We know that Danielle doesn’t have any dangerous debts, such as accounts in collections, credit cards with sky-high interest rates, or expensive payday loans. If she did, those would need attention before addressing any other type of debt. As she mentioned in her question, it’s generally best to pay off debt in order of highest to lowest interest rate.

So, assuming that Danielle’s finances are in good shape, how does paying PMI compare with a student loan and a small auto loan balance? While ongoing PMI payments aren’t an interest expense, you can pretend that they are as a technique for understanding their place in your financial life.

Let’s say you borrowed $180,000 for a $200,000 home, giving you a 90% LTV. As I previously mentioned, you need a 78% LTV to request PMI cancellation. So, you’d have to pay down your mortgage to $156,000 to get there. If you’re at the beginning of a loan term, you’d need to shell out $24,000 ($180,000 – $156,000 = $24,000).

If you were paying $100 a month or $1,200 a year for PMI, you could calculate it as a proxy for annual interest on a $24,000 loan. That comes out to an effective interest rate of 5% ($1,200 / $24,000 = 0.05). That’s an amount you’re paying on top of your mortgage interest rate. So, if your mortgage costs 4% in this example, you’d really be paying more like 9% during the years that you pay PMI.

The benefits of accelerating mortgage payments to get rid of PMI decrease if you’re able to deduct mortgage interest and PMI on your taxes.

However, this is an imperfect calculation because it’s doesn’t account for many factors. These include how much extra you pay toward your principal mortgage balance, how quickly equity builds as you prepay it, and any home appreciation.

Also, the benefits of accelerating mortgage payments to get rid of PMI decrease if you’re able to deduct mortgage interest and PMI on your taxes. A fixed-rate mortgage that costs 4% may only cost you 3% on an after-tax basis, depending on your effective income tax rate.

In general, prepaying a mortgage to eliminate PMI ahead of schedule may not help you as much as paying down other types of debt. Depending on where you live, factors such as real estate appreciation and general inflation are likely to work in your favor, making you eligible for PMI cancellation sooner than you may think.

A super simple way to evaluate the interest rate you’re paying for a mortgage with PMI is to tack on a percentage point or two. For instance, if your pre-tax mortgage rate is 4%, consider it actually costing you 5% to 6% tops. Or if you deduct interest and PMI, don’t factor in the tax implications and just consider the mortgage costing you the same as its stated interest rate, or 4% in my example.

If your other debts cost more than these very rough mortgage interest calculations, I’d be aggressive about getting rid of them first. Again, go in order of highest interest rate to lowest.

However, if you have a small outstanding balance that you just want to wipe out, there’s nothing wrong with that. Even if it costs you slightly less in interest, sometimes it just feels good to get rid of a small debt that’s been weighing you down.

What’s most important is that you understand how much you owe, the interest rates you’re paying, and that you have a plan for eliminating debt. Even if you don’t have extra money to pay off debt ahead of schedule, tacking them in the right order helps you save the most interest so you can eliminate debt as quickly as possible.

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The Pros and Cons of Refinancing an Auto Loan

Woman refinancing her auto loan

Over the last decade, the rising cost of new and used cars have driven up the amount of the average car loan. To make up for this, auto lenders have started offering longer car loans that let consumers borrow more with a lower monthly payment.

The State of the Automotive Finance Market from Experian states the average new car payment worked out to $554 during Q1 of 2019 while the average used car came with a monthly payment of $391. Worse, the average new car loan worked out to $32,187 while the average used car loan was $20,137. Meanwhile, the average loan term was more than 68 months for new cars and almost 65 months for used. 

It’s never fun owing money on your car, but borrowing too much (or borrowing money for too long) can leave you wishing you had a different auto loan. This is especially true if your loan has a high interest rate because you had shaky credit when you applied.

If you’re on the fence about refinancing your auto loan, it helps to know how this move could help you or hurt you. Here’s everything you need to know. 

Pro: You could secure a lower monthly payment

Depending on the details of your initial loan, it’s possible refinancing your car loan could secure a lower monthly payment you can more easily afford. This can be important if you’re struggling to keep up with your payment as it stands, or if you just need more wiggle room in your monthly budget.

With a lower monthly payment, it might be easier to stay on top of your living expenses and other bills. And if you plan to keep your car for the long haul, you may not mind extending your repayment timeline in order to lower your payment each month. (See also: Cutting Your Car Payment Is Easier Than You Think)

Con: You may extend your repayment timeline

Getting a lower monthly payment can be a boon for your finances, but don’t forget you’ll likely be stuck paying on your car loan for months or years longer than you would have otherwise. And this can create unintended financial consequences later down the road. 

This is especially true if you’re extending the loan on a used car that’s already several years old. You could be stuck making payments on an older vehicle that breaks down and requires pricey repairs. This could be a double whammy for your finances later — even though refinancing saves you money on the front end. 

Pro: You could get a much lower interest rate

Another potential advantage of refinancing is the fact you might be able to qualify for a lower interest rate. If that’s the case, refinancing your auto loan could save you hundreds — or even thousands — over the life of your loan. 

Imagine your current auto loan balance is at $15,000 and you have a 19 percent APR and 48 months left on your loan. From this point forward, you would pay an additional $6,528 in interest before your loan is paid off in four years.

If your credit score has improved, however, you might qualify for a new auto loan with a better rate. By refinancing into a new 48-month car loan at 9 percent APR, for example, you could reduce your future interest costs by more than half to just $2,917 while lowering your monthly payment in the process. 

Con: You might pay more interest over the life of your loan

Before you take steps to refinance your auto loan, make sure you run the numbers with an auto loan calculator so you can compare your total interest costs. Securing a lower interest rate or lower monthly payment may be a better deal in the short term, but you may wind up paying more interest on your loan due to a lengthier timeline.

Pro: Tap into any equity you have

Refinancing your auto loan can also help you tap into any equity you have in your car. This can be a lifesaver if you need money for emergencies or simply want to consolidate debt at a lower interest rate.

Just remember that, as highlighted above, refinancing could mean more interest paid over time — even if you get a lower rate. 

Cons: Refinancing isn’t free

Finally, don’t forget that refinancing your car loan typically comes with fees. These fees will vary depending on the auto lender you work with, but they can include an application fee, an origination fee, and an auto lien transfer fee.

Also, make sure to check that your initial car loan doesn’t charge any prepayment penalties that will come into play if you refinance your loan. 

Should you refinance your car loan?

Only you can decide if refinancing your car loan makes sense. It’s possible switching to a new loan could save you money on interest and/or leave you with a lower monthly payment, but it’s also possible a new loan will leave you paying more interest and more fees over time.

Make sure you run the numbers before you move forward, but only after comparing auto refinancing offers from at least three different lenders. By comparing multiple lenders, you’ll improve your chances of ending up with a new auto loan that will leave you better off. 

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The rising cost of new and used cars have driven up the amount of the average car loan. Here's everything you need to know about refinancing your auto loan. | #debtadvice #personalfinance #moneymatters 


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