While the average buyer spends 19 hours researching an auto purchase (according to JD Power), he or she does not do enough homework when taking out a car loan. Despite the fact that failing to shop around for financing could cost consumers more than spending an extra few hundred dollars for their autos, the nonprofit Center for Responsible Lending says that 80 percent of buyers simply take whatever car loans are offered by dealerships.
How much could they be leaving on the table? A lot -- the average markup on financing at the dealership is nearly 2.5 percent. Paying 12.5 percent instead of 10.0 percent on a $25,000 car loan over five years is akin to paying about $1,500 too much for the vehicle!
The good news is that it's not that difficult to do a better job of shopping for car loans.
APR versus Interest Rate
Auto lenders provide two figures when disclosing their car loan rates -- an interest rate and an annual percentage rate, or APR. The interest rate depicts the rate used to calculate the vehicle's monthly payments. If financing $10,000 over five years, for example, a 7.5 percent rate creates a $200 monthly payment. However, if that loan comes with $500 in financing charges, that $200 payment only actually covers a loan amount of $9,500, because $500 of the money borrowed went to the lender. In that case, the same size payment covers a smaller loan amount, so a more accurate depiction of the loan amount is the APR. In this case, it's 9.58 percent. That means a 7.5 percent loan with $500 in fees is actually more costly than an 9.5 percent loan with no fees.
When comparing two loans with the same term (in the above example it's five years), the loan with the lower APR is the better deal.
The shorter a loan's term is, the less interest will be paid overall. Buyers who finance $10,000 for five years at five percent ($189 per month payment) pay $1,323 in interest, but just $790 by financing for three years instead ($300 per month payment). An added bonus is that loans with shorter terms almost always come with lower interest rates, saving borrowers in two ways.
A five-year loan from one lender online in September 2014 carries an interest rate of 5.84 percent, while a three-year loan from the same lender has a rate of just 4.75 percent. That translates to a monthly payment of $193 and a total of $1,555 in interest for the five-year loan versus a monthly payment of $299 and total interest of $749 for the three-year financing.
The other problem with longer-term loans is that it takes longer for borrowers to build equity in their vehicles -- unlike houses, cars usually go down in value, which means it takes a more aggressive repayment strategy to overcome that and avoid owing more than the car is worth. Being "upside down" with a car loan can be risky if a vehicle is totaled and the insurance settlement won't cover the remaining balance. To be safe, Consumer Reports recommends shorter loan terms and at least a 15 percent down payment or trade-in value when purchasing a vehicle.
Rebates versus Zero Percent
Having a car loan lined up before shopping for cars lets consumers compare offers more easily and avoid being sucked in by dealer tactics like getting them to focus on monthly payments instead of actual costs. However, not all dealer financing is a bad deal -- it's hard to get lower than the zero percent financing dealerships might offer as incentive to purchase from them. Those offers often allow buyers with their own financing to get a rebate on their purchase price instead.
Auto calculators can help make the choice easier -- for example, Dealer A offers their truck for $25,000 with either zero percent financing for 48 months or a $1,500 rebate. Dealer B offers theirs for $23,000. A local credit union offers a 48-month loan with a 3.5 percent rate. Here are the costs for all three options over four years. In this case, buying from Dealer B and financing through the credit union is the best deal.
|Dealer A Financing||Dealer A Rebate||Dealer B|
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How to Get the Best APR
Interest rates and APRs are not set in stone rates. They are determined by the market, the lender and, most importantly, your credit score. The better your credit score (aim for a 780 or higher), the better interest rate you'll receive. Take a look below to see exactly how your credit score is impacting your APR.
As you can see, the lowest rates are reserved for those with excellent credit who choose a short-term loan (in this case, 36 months). The lower your score, the more you'll pay in interest for your auto loan.
You can work at improving your credit by paying all of your bills on time, keeping your credit card balance low, and disputing any errors on your credit reports.
How to Get the Best Deal
Car buyers who wish to compare deals have two powerful tools at their disposal. The first is LendingTree's auto calculator. Users simply input the numbers for each option -- adjusting the price / loan amount to reflect rebate and differences in the price of the car as well as the interest rates being offered. The must use the same term (48 months, 60 months, etc.) to make the comparison valid, and should choose the option with the lowest total cost. There is even a spreadsheet they can download and use to compare offers from multiple dealers without being online.
The second tool is My LendingTree. Users can get their free credit score and then by clicking the "Auto" tab, they can get real offers for auto financing. Consumers can apply with just a few clicks. Then, armed with a few competitive offers, they can head to the dealers and negotiate their auto purchase.