Dangers of Using Student Loans to Buy a Car

When the federal government handed out the first student loans in 1958, the message was simple: This money is to be used for education purposes, meaning tuition, books, fees, supplies and living expenses such as room and board.

No mention was made of using the money to buy a car.

Student loans are meant to equip you with a lifetime of knowledge. Cars are meant to equip you with a pocket full of expenses that start before you even get the keys.

So, before you stop at student financial services on your way to a dealership, take a minute to read why buying a car with student loans 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 Student Loans to Buy a Car?

Technically, when you take out a student loan, you agree that the money will be used for educational expenses. You could make the case that the only way to commute to school is with a car, and in reality, there is no oversight once the student loan money drops into your bank account.

You could cash the check and head to a car lot or anywhere else and spend the money.

A better question is, “Should you use student loans to buy a car?”

The answer: “No!”

It might seem like a good idea at the time, but there are three reasons why buying a car with student loans will cost you more money than you bargained for.

1. Interest Rates

Student loan interest rates are higher than the average rate for a car loan. The average five-year auto loan in 2018 has an interest rate of 4.21%. Undergraduate student loan rates were set at 5.05%, and graduate loan rates are 6.6% in 2018. Direct Plus loans are 7.6%.

2. Loan Terms

The average loan term for cars in 2018 – new or used – was 68 months. That means you’re making payments for 5-6 years, though 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 coming out of school. Many graduates opt for income-driven repayment plans that can extend the loan term to 20-25 years. You don’t want to be in a situation where you are still paying for a car 10-20 years after you bought it and probably don’t even drive it anymore.

3. Devaluation

A brand-new car will decrease in value 20% in the first year, and all cars depreciate about 10% per year after that.

Kelley Blue Book

Let’s say you bought a 10-year old Honda Accord for $7,645 — the Kelley Blue Book value – with money from student loans at 5.05% interest. After 10 years of student loan repayment with the Standard Repayment Plan, you will have paid a total $9,753 for an asset that is now 20 years old (if you still have the car) and worth only $2,641. That’s a loss of $7,112.

Alternatives to Buying a Car with Student Loans

1. Public Transportation

You probably didn’t want to see this as the No. 1 suggestion, but AAA estimates the annual cost of owning an average sedan in 2018 at $8,469. Insurance, maintenance, gas, and depreciation all factor into the true cost of owning a car. Take a moment and think about whether you really need a car to get around, and what for? Most colleges are walkable once you get to campus. Nearly all of them have a good bus system to shuttle students around campus and to nearby apartments. If you need transportation home, you can also charter a bus from Greyhound and MegaBus. Not always convenient, but a lot much cheaper than owning a car. Think about that before you take on debt you’ll end up regretting.

2. Bicycle or Scooter

College campuses are very bicycle and scooter friendly. You’ll never have to worry about parking or adding student debt. You can find a good second-hand scooter for less than $1,000 or a bike for a couple hundred dollars. If you need to go across town, you can commute there by combining your bike with a bus route. Hang it on the rack of the bus, and bike from the stop to your final destination.

3. Save Up Cash in the Summer

If you absolutely need a car, avoid financing it with student loans at all cost. Your best option is to work a job in the summer and weekends during the semesters. Save up the money and buy a cheap used car. Check with local mechanics for a good deal. Often, they’ll fix up unwanted cars themselves and sell them on the cheap. Family and friends are often a good resource for finding a deal from someone willing to help out a college student.

How to Find the Best Auto Loan as a Student

It will be a difficult task as a student to find an auto loan. Lenders want to see a credit history that includes low debt-to-income ratio (DTI) and a good credit score.

Most college students with loans have little to no income and borrow a substantial amount to pay for tuition. On top of that, their credit history is relatively new and likely not as diverse as lenders would like to see.

But if you have scholarships that take care of your tuition and a steady income, it’s worth giving it a shot. You can build a positive credit history by taking on a credit card with a low spending limit ($1,000 or less), use it sparingly and pay it off at the end of every month. Also, pay your rent and utility bills on time and ask them to report that information to the credit agencies.

That will help you establish a solid credit score and that’s where the possibilities for getting a good auto loan 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 to be above 700 and debt-to-income ratio below 40% for 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 preapproved for a loan. Adding a cosigner might alleviate some of the issues college borrowers have with credit history.

Don’t Fall Victim to Buy Here, Pay Here Dealerships

Consumers who see a “Buy Here, Pay Here” used car lots should view it as a warning sign, not an invitation to a good deal. You might be approved on the spot, but take a very close look at the terms. The average interest rate from these dealers is a whopping 19%.

Buy Here, Pay Here owners don’t have a problem approving high-risk borrowers. They’ll saddle them with extremely high interest rates with monthly payments they know the borrower can’t afford. When the borrower misses a payment, the owner repossess the car and sells it to another customer.

Should I Use My Student Loans to Lease a Car?

In most cases, any financial adviser will tell you that leasing a car is a bad idea. One of the few situations that might make sense is if your only option is to finance a car with student loans.

You don’t want to borrow money (student loans) to pay for more borrowed money (an auto loan). You’ll be paying interest on the front end and the back end.

Leasing a car with student loans might work if you have a cash flow problem. You don’t have income to afford monthly payments on a traditional car loan, so the issue comes down to taking out student loans to pay cash for a car or lease a car.

Either way, you are going to be adding student loans. The goal is to add the least amount.

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 loan is an easy and familiar process to most students, and if you are taking out tens of thousand of dollars to finance your education, adding another few thousand feels like another drop in the bucket.

But consider this: nearly half of college graduates that have student loans are in repayment plans that take more than 10 years and up to 25 years. You could still be making payments on your college car, while you shop for your kid’s first set of wheels.