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should you sell your car to pay off debt?

Should You Sell Your Car to Pay off Debt?

Should you sell your car to pay off debt? Today I’m answering this question from a reader.

Question: We are working on our debt snowball, and I have a question about our car payment. One car is paid for, and the other car is $489 a month. We owe about $18,000, and we could trade it in for about $10,000. Should we sell it and take out a loan for the difference to pay off our debt faster, or should we keep making the payments? Thanks! – Jenny

This is a FANTASTIC question and it’s one that doesn’t have a quick yes or no answer. Let’s walk through the steps to figuring out your best options so that you can make a decision you’re comfortable with: one that considers both your need for reliable transportation and your financial goals.

 

Step 1: Do You Need to Sell Your Car to Pay off Debt?

The first step is to decide if the value of the car is proportional to your income. A good rule of thumb is to add up the value of everything with a motor that you own. This includes cars, boats, RVs, etc.

Is the worth of those things more than 50% of your annual income? For example, if you make $60,000 a year and own two cars, does the total value of the cars exceed $30,000?

If so, then I would strongly consider downgrading so that you are below the 50% threshold. The reason is you don’t want to have too much of your net worth tied up in stuff that goes down in value.

Anytime you’re thinking of purchasing a new car, this is a good guideline to remember to keep your net worth going in the right direction!

 

Step 2: Assess How Quickly You Can Pay off The Car

When you put the car in your debt snowball, how long do you estimate it will take to pay off?

Related: What’s the Best Method to Pay off Debt?

Can you pay it off within two years? And, is the car meeting your transportation needs? Do you like the car enough to pay this much money?

If you can pay off the car within two years, you like the car, and you plan to keep it well after it’s paid for, then it might make the most sense, both practically and financially, to simply pay it off and keep it.

If you find yourself breathing a sigh of relief, like yes I am so happy Lauren isn’t telling me my car payment is absurd! then I’m guessing you are really content with your car and continuing to pay it off per the snowball method is your best option.

Cool! But, keep reading because there might be another option you haven’t considered yet.

If, however, your car is going to take more than two years to pay off, it’s likely slowing your debt snowball momentum and is holding you back from your debt-free goal.

In this case, I’d move on to the next step for sure.

 

Step 3: Take Out a Loan for the Difference

Okay, I know it says “take out a loan.” Gasp. We’re not talking about new debt, though. This loan is a personal loan, usually available through your local credit union or bank, to cover the difference in equity. In Jenny’s case, the difference is $8,000 if she trades it in.

Quick tip: Don’t trade in your car to a dealership. Always go for a private party sale and use a reputable website like autotrader.com. Look at what similar vehicles in your area are selling for and also use the Kelly Blue Book value to determine your asking price. You’ll get top dollar for your car instead of selling it at a wholesale price to the dealership.

Related: How I Buy Reliable, Cheap Cars

So in Jenny’s case, she’s probably not really upside down on the car by $8,000. Maybe more like $3,000-$4,000 if she sells it herself (that’s worth a little elbow grease to ready a car for sale if you ask me!)

But she is still upside down and will need a loan to cover the difference, plus a couple thousand dollars to purchase a beater car.

Since we’re on the subject, let’s talk about what a bummer it is to sell a nice car that you have a payment on and trade it for a beater that you still have a payment on.

It doesn’t feel like it makes much sense in the short term. After all, you might reduce your minimum payment from $489 to $220, but is a couple hundred buck a month really worth it? You might have to spend more on repairs and maintenance than you would on the nicer car.

This is true. But, let’s look at the rest of the financial picture.

Between what it takes to pay off the negative equity, plus say you buy a $3,000 car, you have effectively reduced your car debt from $18,000 to $7,000, a total debt reduction of $11,000. Now your car payment moves up in the snowball order (presumably) and the minimum payment is less, which enables you to pay down the principal faster. Stay tuned for step four- that’s where the fun and the financial payoff really starts.

Plus, if you follow this checklist to buying your cheap car, it’s a very realistic expectation to find a set of wheels that won’t constantly be in the shop. (Don’t skip those important steps!)

 

Option 2: Another Way to Get Rid of Your Car Payment

Taking a loan to pay for the difference isn’t your only option, though. If you don’t like the idea of reducing the debt and want to eliminate car debt entirely, you always have the option of continuing to pay down the loan until you have some equity in the car. Then you can sell the car and pay cash for a downgrade.

This option, like most, has pros and cons. Paying down the loan before selling your car could be your best option if your credit isn’t high enough to qualify for a personal loan. And if that’s the case, it may be your only option.

It’s also a good option if you simply like the idea of not having to deal with the hassle of exchanging one loan for another. However, it also means you’ll be continuing to make payments on a car you aren’t planning to keep. And if the car gets damaged in the meantime, the value goes down, thereby extending the time it will take to acquire equity.

 

Step 4: Save Cash for a Car Upgrade

The “beater” car isn’t meant to be your forever car. It will last a few years and then go kaput. So, you will want to prepare financially to never have car debt again.

And not only that, but by following this system, you’ll be able to continually upgrade your car, gain flexibility in your budget, and earn interest instead of paying it in a car loan.

Here’s what to do: determine approximately how much longer your debt snowball will take to complete. Let’s say in Jenny’s case it will take 20 months after she decides to get a loan for the difference of what is owed on the car, shaving a year off their debt freedom journey (that’s a pretty average scenario in my experience).

This means they should plan to drive that car for about two years. Once all the debt is paid, think about how much money can be redirected to saving for upgraded transportation! It should only take about four months to save a few thousand dollars, plus they can sell the beater for at least $1,000.

So now they have about $5,000 for a used car. It might not be a brand new sports car, but $5,000 will get you a pretty decent set of wheels. Nothing fancy, but it will be reliable transportation.

This is their car for baby step three, which is funding the full emergency fund. Let’s presume that takes 15 months. Now they’re in great shape! Not only are they in an excellent financial position to begin building wealth through wise investing, but they can also determine how much they want to save every month for their next car upgrade.

Let’s suppose they take what they were paying- $489 a month- and save that for 12 months.

Now they have $5868 saved, plus a car that has likely only depreciated by $1,000 in that short 26 months of ownership. All together, that gives them $9,868 for their car upgrade.

What we’re looking at here is in a span of under four years, Jenny and her husband will have gone from struggling with payments on a car that has negative equity, to owning a $10,000 car outright. And what’s more, they have the means to continue to save for car purchases at their own pace and in balance with their other priorities.

They will never have a car payment again!

At the end of the day, the goal of being debt-free is the same, no matter how you get there. Depending on your income, the value of the car, and how much faster you could be done with the debt snowball are all important factors when it comes to deciding whether or not to sell your car to pay off debt.

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should you sell your car to pay off debt?

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