Auto Financing: Kicking the Tires

Easy auto financing has helped car sales be one of the bright spots of the economic recovery. Handled correctly, auto loans can be the key to providing necessary transportation. With the wrong loan terms though, auto financing can cause the type of unmanageable debt burdens that previously led to an epidemic of mortgage defaults in the housing industry. Some sensible questions can help consumers make the distinction between the right loan and a rip-off.

After all, most people wouldn't buy a car without kicking the tires a little -- taking a test drive, looking under the hood, etc. It's well worth the time to give auto loans the same scrutiny.

The Boom in Auto Financing

Federal Reserve figures show that the dollar amount of auto loans outstanding has increased by about $200 billion dollars since 2009. For the most part, this has been a good deal for consumers, because loan rates have dropped so steeply. The average interest rate on a 4-year auto loan is more than 2.5 percent lower than it was in 2009.

Unfortunately, some consumers pay considerably more than the average. The Economist magazine recently reported that there has been a surge in subprime auto financing - loans to people with limited or damaged credit histories. Subprime auto lending has increased by 93 percent since 2009, but the easy availability of this credit comes at a cost. The average rate for subprime auto loans is 14 percent, and often runs to 25 percent.

Too much borrowing, and at too high a price, can put consumers in a trap where the loans take longer to pay off than the cars last. Like all borrowing, auto financing should be a temporary means to an end, not a permanent drain on the car buyer's budget.

Kicking the Tires on Auto Loans

Here are some key questions auto buyers can ask to make sure they are getting loan terms they can live with:

  1. Does my credit need a tune-up? Paying off a debt here and clearing up a problem there can clean up a credit history, and help the borrower qualify for a better rate. 
  2. How much should I be borrowing? Sometimes, borrowers are so relieved to get financing that they will pay more than a car is worth. Or, they will finance various add-on charges along with the price of the car itself. The result is that the average subprime car loan is now 115 percent of the car's value. This makes paying off the loan within the useful life of the car a steeper climb.
  3. Is the dealer the best source of financing? Car dealers - especially the ones with loud, obnoxious advertisements - love to pitch that nobody will be turned down for credit. This is because they then tack on a generous cut for themselves to the actual cost of the loan. Chances are that the dealer is not the best source of financing, but in any case car buyers won't know for sure until they shop around and get competing quotes from auto lenders.
  4. Am I being shown an APR that includes all fees? Before a buyer starts comparing quotes, it helps to get apples-to-apples figures by insisting on APR figures that include all loan-related fees and charges, as opposed to just the simple interest rates. 
  5. Are their cheaper alternatives? Car buyers should consider whether an auto loan is the most cost-effective route to financing the purchase. For example, someone with equity in a home might consider using a home equity loan instead. The key is being confident enough in ability to repay that the loan won't endanger the home owner's property. 
  6. Does this payment fit my budget? Just because a lender is willing to make a loan does not mean the borrower can afford it. A borrower should look at existing income and expenses to see whether or not the proposed car payment fits.
  7. How much am I really paying for this car? One way to put the whole thing in perspective is to look at an amortization schedule showing all principal and interest payments, to see the total amount buying the car with these loan terms will really cost over the long run. 
  8. How long am I going to be paying for this car? The idea is to pay off the loan and have a few years of owning the vehicle free and clear in order to start saving some money. Unfortunately, the length of car loans has been stretched out over the years, which can be especially risky when buying a used car. The loan should last less time than the probable useful life of the car. 

Americans have traditionally had a love affair with their cars. Avoiding unfair loan terms can help make sure that affair does not turn into a love/hate relationship.

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