One thing I’ve learned after making student loan plans for over 5,000 people is that cars are one of the primary culprits of financial insecurity in America.
According to Kelley Blue Book (KBB) the average new car price eclipsed $40,000 for the first time at the end of 2020. That’s a price tag so high that paying all cash would be difficult for any buyer and especially college students. Yet if you don’t have a long credit history (as many students don’t), it can also be difficult to qualify for a five-figure car loan at all (much less at a reasonable interest rate) without a cosigner.
It’s for all these reasons that many students wonder if they can use student loans for a car. After all, federal student loans (and generally private student loans as well) can be used to pay for living expenses, including transportation. Also, student loans come with low fixed interest rates, deferment while you’re in school, and long repayment periods of more than 10 years.
That all sounds pretty nice on the surface. But when you look deeper, you’ll find a variety of legal, ethical, and financial problems. Below, I explain why you definitely should not try to buy a car using a portion of your student loans. And I also want to show you how to get a free car with a hack that seems simple, but few seem to utilize.
Can you use students loans for a car?
So first let’s cover the surprising news. Yes, you technically could use part of your student loans to purchase a car. But is it legal to do so? No.
Here’s how the student loan process works. The maximum loan that the Financial Aid office or your private loan lender will send to your school is based on its published Cost of Attendance (COA) minus any other financial aid you may be receiving.
Your school first uses the funds it receives to pay for your direct education expenses (tuition and fees). But any student loan money that’s left over will be disbursed directly to you to be used to cover books, supplies and living expenses such as campus housing, food, and transportation.
Once that money is in your bank account, you ultimately have full control over how it’s spent. So you could decide to use part of the money to make a significant down payment on a new car. But keep reading to learn why you shouldn’t.
Is it legal to buy a car with student loans?
In the case of federal student loans, the answer is a clear no. Each year, the Department of Education publishes its Federal Student Aid handbook which details the kinds of expenses that can be included in a student’s COA.
While using federal aid funds to buy gas or pay for car repairs is allowed, the 2020-2021 Federal Student Aid Handbook (as well as all previous editions) expressly forbids the use of federal student aid to buy vehicles. Here’s a direct quote from Volume 2, Chapter 3:
An allowance for books, supplies, transportation, and
miscellaneous personal expenses. This allowance can include: Costs for operating and maintaining a vehicle that is used
to transport the student to and from school, but not for the
purchase of a vehicle.
Is there a chance that you could get away with using your students loans for a car without getting caught? Sure. But, first, this would be unethical based on the rules. And, second, if you did happen to be reported to the Office of Federal Student Aid fraud hotline, your student loans could be revoked. At worst, you could face jail time.
Are the potential benefits worth all that risk? Certainly not. Why? Because buying a new car with student loans not only enters you into a legal and ethical minefield, but it’s usually an awful financial move too. Here’s why.
Is a student loan an affordable car financing option?
At first glance, buying a car with student loans might seem like a great way to save money. If you’re not a prime borrower, the interest rate you’re offered on a traditional car loan could be more than 10% according to Cars Direct.
But the Department of Education doesn’t do a credit report check on undergraduate borrowers. So even if you have bad credit, you get the same lower interest rate (currently 2.75%). How could you not come out ahead, right?
In reality, you’ll probably spend far more in interest by buying a car with a student loan rather than going with traditional financing. Why? There are a few reasons.
First, student loans have substantially longer repayment terms. Edmunds says that the typical car loan length is 72 months. Meanwhile, the Standard Repayment Plan for federal loans takes 10 years to complete. And if you join an Income-Driven Repayment (IDR) plan, you could be making payments for 20 to 25 years. That’s four to 19 more years of paying interest.
If you take out Direct Unsubsidized Loans, Grad PLUS loan, or private student loans, interest will accrue while you’re in school. And if you don’t pay off that unpaid interest before normal repayment begins, it will capitalize (be added to your principal).
Let’s say Alice takes out a six-year car loan at the start of her freshman year. Tom, also a freshman, decides to use student loan funds for his car purchase instead. Both end up earning their bachelors and masters degrees over six years. By the time they both leave school, Alice would be nearing (or have already reached) her loan payoff date. Tom, meanwhile, wouldn’t have been paid down a single cent of his loan and it would already accrued six years of interest!
Lastly, federal student loans charge disbursement fees that range from around 1% to 4%. So, risks and ethical issues aside, student loans are unlikely to be a cost-effective way to buy a car.
The only way student loans would be a good way to buy a car is if you planned on going for forgiveness. Technically, you could finance the vehicle and keep the funds in your bank account to avoid it being a direct purchase. Money is fungible, meaning that while you can’t technically use student loans to buy a car, you can use student loans to replace money that was used to buy a car that could’ve covered living expenses instead.
Keep reading to learn a better way to save.
Most common ways to get a car
Here are the three most common ways to drive a car in the United States currently:
- Pay cash, either at the dealer or with a private party
- Lease a car at the dealer
- Finance a car at the dealer
According to the New York Times, only about 10% of folks choose option one and pay cash outright for their vehicles. Data from Experian shows the average car payment has crept up to $554 a month. It’s staggering to me that the norm for buying a car in America is to use financing. But it makes sense since so few people have more than $5,000 in the bank.
Very few decisions will wreck your finances more than consistently financing or leasing new vehicles. Even the cost of attending a $500,000 degree program can be managed thanks to the various strategies we use with Income-Driven Repayment and forgiveness.
However, you can’t forgive your way out of a car payment (unless you don’t care about your credit score). If your friend has messed up finances, chances are its either because he has a rent or car payment that’s too high relative to income.
I’m going to show you how to get a steal of a deal the next time you’re in the market for a new car. If you have big student loans, it’s critical not to make and repeat the new car mistake.
Preparing to buy a car: start saving
Before you do anything else financially, you need an emergency fund. You need to make sure your income is higher than your expenses and rapidly pay down any consumer debt.
The ironic thing is most people don’t have $5,000 to $20,000 in the bank. And this causes them to sign up for a monthly car payment and then their expenses are so high they never get enough savings to pay cash for a car. It’s a vicious cycle.
Regardless if you’re going to buy an old $2,000 Honda Civic or a $20,000 almost new Toyota, you have to prepare for that purchase right now if you’re not already rich. If you had to take out student loans, you’re probably not in the “my parents got me a Mercedes for Christmas” club.
Hence, the first step in being free from a car payment is to save at least $5,000 in cold hard cash.
Getting rid of a car that’s worth less than what you owe
It’s not easy to get rid of a car when you owe more on it than you could sell it for. That’s called being underwater.
Sometimes I see folks with plenty of cash who have loss aversion and they don’t want to pay off the car note because they’d be admitting they made a mistake. Get over it. If you can pay off your car loan do it.
If you can’t, then one option would be to see if you could trade down to a cheaper payment. Shop it around different places like CarMax or a dealership. It’s better to avoid $10,000 of depreciation and take a $2,000 hit today to get out of it.
Avoid buying a car at the dealer: The secret 0% interest trick
Have you ever had a friend brag to you about the low rate they got on their car note? Often clients will tell me that they have a 0% rate on their note or close to it and that they feel great about the deal they got.
Bubble bursting warning: there’s a very good chance dealers are better at math than you are.
Have you ever seen a dude standing at the intersection touting 0% loans for furniture store purchases? How can they afford to do that?
The simple answer is that you can take a $200 couch and mark it up to $1,000 as long as you can secure financing for a customer. At 0%, the rate makes them feel like they got a good deal even though they paid five times the cost of the couch.
The same goes for buying a car at a dealer. The cost of producing a vehicle is nowhere near $30,000 for a new car. You mark the vehicle up above the real value and then get creative with financing. As long as your defaults come in below what you expect, then you made a ton of money tricking consumers into paying a premium price.
No, you didn’t get a great deal if you got an auto loan rate below 5%. You could’ve bought one used from a private party for at least a 25% savings.
How to buy a car on Craigslist instead
It’s all well and good for me to go on the warpath against buying a new car, but what are the alternatives? Here’s a step-by-step guide on how to buy a used car on Craigslist for thousands less than the dealer.
You want to know how to get a free car right? If you can sacrifice driving a clunker for two years, the $400 to $500 per month you’d spend on a car lease or purchase can go into a savings account instead. At the end of the two years, you’ll have enough to pay cash for a very nice car the way I’ve outlined below.
Two years of sacrifice for a new car that you’ll be able to drive for seven to 10 years is pretty cool. Here are the steps.
- Go to your local Craigslist.com and click on “Cars+Trucks”
- Select “owner” only. You don’t want results from dealers polluting the results because you won’t find deals that are as good.
- Add your price range. I prefer $5,000 to $10,000 because the car will be safe enough not to waste a bunch of time at the mechanic.
- Add a model year. I generally prefer cars newer than 2012 with over 100,000 miles on them. New enough that the miles are probably all highway. High enough miles that people irrationally panic, and I can get a model for a cheaper price.
- Contact folks on the site and ask for the car’s VIN number. You’ll want to run this through one of the many cheap sites out there that allow you to get vehicle reports. Set up a test drive and call your insurance first to make sure you’re covered (you should be).
- Call ahead to a local mechanic you trust, and ask him to inspect the car and tell you how much work you think it’ll need in the next 20,000 miles. I only buy cars that have clearly been well maintained after the mechanic report. Note: I have no clue about vehicles and hire out everything.
- I’d suggest setting up a separate time to give the owner a certified cashier’s check from your bank in a place where you can sign over the title. I’ve done this at a private title registration office and a local bank on different occasions. While you can certainly do it in cash, I wouldn’t suggest it.
- Before you drive it away, make sure you have insurance set up beforehand. You’ll probably have to mail some documents to show the ownership change.
How much do you save by driving a paid off car?
I had a dual dentist couple as clients recently who leased cars in the $400 a month range. That cost is about $10,000 a year for the monthly payments.
You also have to pay a bit extra in insurance premiums that should be amortized over the life of the lease term. Let’s say all in, they had to pay $12,000 more per year than if they owned their own car.
Over 10 years, this would be $120,000. However, that money is after-tax. They had a lot of student loans and were going for forgiveness. That means their marginal tax rate was 50% thanks to the hidden 401(k) match with student loan debt.
In other words, that $120,000 would actually be $240,000 of pre-tax salary if it was invested for retirement instead. The maximums for a couple for retirement savings are $18,500 in 2018 and $19,000 in 2019 per person. So the idea that they could’ve put the money into retirement is very much real.
Investing at 8%
Avoiding a Car Lease is Worth
In 10 Years
In 20 Years
In 30 Years
In 30 years, the couple could’ve had $1.75 million. This is solely from the decision to drive a paid off car for 10 years in early adulthood after professional school graduation.
When is driving a new car a financially responsible decision?
I have no problem with you buying a new car. I just want it to be done in cash. Rich people make financially silly purchases all the time. Bill Gates lives in a massive multi-million-dollar mansion because he can easily afford it.
A new physician or dentist or lawyer with $200,000 or more in student loans can’t afford a new car. At least, not if you want to buy a house, have a family, retire before 65, and responsibly handle your debt where it won’t give you anxiety.
You can get approved. But that’s because they’re assuming you’ll work until 70. You might do that. But it would stink to do that because you had to rather than it being your desire.
Why you don’t want a car payment and a student loan payment
Having big student loans means you want to have a high savings rate so you can build your assets. Once your net worth is positive, you don’t have to stress out so hard.
Buying a car on credit or lease does the exact opposite of building wealth. You’re financing an asset that depreciates in value. At least homes generally go up at the rate of inflation.
So the next time you buy a car, patronize your friendly 88-year-old neighbor who garaged their 2013 Prius for eight years and has to sell it so they can move into the assisted-living facility. Nab the great deal on the sports car you wanted from the new dad who needs the four-door sedan.
Purchase luxury, but do it with a 2018 Acura instead of a 2021 Acura that you lease. Changing your purchases this way can literally make you a millionaire.