Financing a Car: A Guide to Getting Your Wheels
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If you’re like most people, you need reliable transportation to function in your everyday life. Maybe you need a car to get back and forth to work, or to drive your children from school to soccer practice. Whatever the reason, it’s paramount you find an automobile that is both practical and affordable.
Unfortunately, cars — and especially new cars — cost a pretty penny. According to the latest Experian State of the Automotive Finance Market study, the average new car loan in 2017 worked out to $30,234, while the average used car loan was $19,189.
With so much money required to get behind the wheel, it’s no wonder consumers often choose to take out a car loan and make monthly payments.
But how do you take out a car loan? Borrowing money for a car works similarly to taking out other types of loans. You apply for a loan and if you are approved, you make monthly payments until the balance is paid off.
Generally speaking, you’ll want to check your credit score, shop around for an auto loan with various financial institutions, then pick the loan with the best interest rate and terms. You’ll also want to save up as much of a down payment as possible. Not only will this reduce the amount of money you need to borrow, which can lower your monthly payment, but you might also qualify for a better rate on your auto loan with a larger down payment.
How much car can I really afford to finance?
While borrowing can make purchasing a nicer vehicle more attainable, it’s still important to make sure your car purchase makes sense with your budget. Not only should you make sure you’re not overspending on the total cost of your vehicle, but you should make sure your monthly payments are affordable, too.
The CFPB suggests a set of steps to ensure you’re not overspending. For example:
#1: Determine how much car you can afford.
When taking out an auto loan to purchase a car, you’ll need to consider both the overall costs of the car and the monthly payment. The CFPB suggests trying out the Federal Trade Commission (FTC) “Make a Budget” worksheet to help determine how much car you can afford.
Keep in mind that your car payment needs to make sense with your income and your other bills. To that end, it might help to write down how much you earn each month and consider that figure in the context of your regular bills and liabilities. For example, you might bring home $4,000 per month and pay out around $2,500 per month for things like rent, utilities, insurance, dining out, day care and entertainment. Leftover money is cash you could save and potentially spend on a car payment plus upkeep and insurance.
If in doubt, you could also consider what’s called the “20/4/10 rule”, which is explained by our subsidiary MagnifyMoney.com, to figure out how much car you can afford. This rule of thumb suggests you should put down at least a 20 percent down payment, finance the vehicle for no more than four years, and keep your total transportation costs under 10 percent of your monthly income.
#2: Don’t forget to look beyond the monthly payment.
While your new monthly payment is important in terms of your budget, you should also consider the total costs of borrowing for your car. You can typically lower your monthly payment by lengthening your car note (i.e. paying a monthly payment for 72 months instead of 60). However, the longer you make car payments, the more interest you’ll pay over that extended time period.
Longer car loans tend to put people in the position of having negative equity, or owing more than their car is worth. For that reason, it could make sense to pay a higher monthly payment in order to shorten the term of your loan and the time you’ll be considered “underwater.”
#3: Factor in all the costs of ownership.
While your monthly payment will be influenced by the price of your car and your interest rate, it’s important to factor in the other costs of owning a car. Not only should you take into account dealer fees (if applicable), license plates, state taxes and title fees, but you could also consider the costs of maintenance, repairs, insurance and gas.
#4: Don’t forget about resale value.
While the purchase price of a car is important, the CFPB notes you should also consider the resale value of your car. Since automobiles lose value rather quickly, it’s crucial to understand how much your car may be worth as you pay down your loan. This is especially true if you plan to sell or trade in your car before you pay it off.
How my credit score impacts my auto loan APR
Individuals with a lower credit score considered deep subprime (credit scores below 500), subprime (scores from 501-600), or nonprime (scores 601-660) typically pay higher interest rates to borrow money for an automobile.
Banks and lenders charge these higher APRs to individuals with low credit scores to make up for the increased risks they face when lending to less-qualified borrowers.
Keep in mind that you can absolutely get an auto loan with bad credit, provided you have proof of income and the ability to repay. However, you’ll likely pay higher borrowing costs overall.
To provide more depth on the subject, the following table illustrates how your credit score can impact the APR on your car loan:
|Credit Score||New Car APR||Used Car APR|
|Deep subprime (credit score below 500)||14.43%||19.73%|
|Subprime (credit score 501-600)||11.35%||16.49%|
|Nonprime (credit score 601-660)||6.92%||10.06%|
|Prime (credit score 661-780)||3.96%||5.42%|
|Super Prime (credit score 781-850)||3.05%||3.68%|
**Source: Average interest rates from the Experian State of the Automotive Finance Market
Mistakes to avoid when financing a car
While borrowing money for a car may be necessary for those who can’t (or don’t want to) save up the purchase price in cash, that doesn’t mean the process is foolproof. If you’re not an informed buyer, or you fail to do your due diligence, there are plenty of car financing pitfalls you could run into.
Before you buy a car or apply for an auto loan, try to avoid these mistakes at all costs:
#1: Focusing solely on the price of the vehicle
While you should absolutely negotiate the price of any vehicle you buy, you shouldn’t focus only on the sales price. Pay attention to the sales price, the monthly costs of ownership and the long-term costs of financing a car. Your monthly payment is especially crucial to consider since you may be paying it for 60 months or longer, for example.
#2: Focusing solely on the monthly payment
Then, there’s the other end of the spectrum. Your monthly payment is an important measure of affordability for sure, but you also need to focus on the total sales price and long-term costs of ownership.
Unfortunately, many people extend the length of their loan to bring the payment for the car they want in line with their budget. While it’s possible to lower your monthly payment by increasing the term of your loan, doing so will increase the amount of interest you pay over the long term. Obviously, this is something you’ll want to consider before you settle on the ideal loan for your purchase.
#3: Not negotiating the sales price
Before you head into a dealership or to an appointment with a private owner, it’s crucial to know what the car you’re buying is worth. Resources like Kelley Blue Book can help you estimate any new or used car’s value based on the car model and year, mileage, and condition of the vehicle.
Once you know a car’s value, you should absolutely negotiate with the dealer or seller to ensure you’re paying a fair price. If you don’t bother to negotiate, you will likely pay more than you should or more than the car is worth.
In addition to negotiating sales price, the CFPB notes you should also negotiate the trade-in value for your old car (if trading in a vehicle), your new loan APR and your loan length.
#4: Forgetting to factor in additional expenses
In addition to the costs of borrowing and financing a car, there are additional expenses involved in owning and maintaining a vehicle. Don’t forget to account for the costs of license plates, insurance (which might cost more for a newer vehicle), upkeep, regular maintenance, and repairs.
#5: Rolling lots of add-ons into your auto loan
Auto dealerships are notorious for offering lots of add-ons you can roll into your auto loan. These add-ons can include things like extended warranties, GAP insurance to insure against rapid depreciation, credit insurance, and additional features like auto alarms, window tinting, and tire and wheel protection.
While buying these add-ons may seem reasonable, keep in mind that rolling their costs into your auto loan will increase your monthly and interest payments over the life of your loan.
#6: Not reading the fine print
Before you sign on the dotted line, make sure you read your auto loan document in its entirety. If you fail to read the fine print, you may be in for an unpleasant surprise. Some lenders will try to add in prepayment penalties for paying your car off early, for example. Not knowing what your loan’s fine print entails can be costly for this reason.
While financing a car can be stressful and even overwhelming, it’s good to know there are so many financing options available. The best type of auto financing for you depends on an array of factors including your credit score, any relationship you might have with a bank, and any dealer incentives offered. Of course, these factors depend on your unique buying situation.
Here’s a run-down of each type of auto financing available, along with their pros and cons.
Bank or credit union
According to Jonathan Olsen of auto financing website rateGenius.com, a bank or credit union is often the best place to apply for an auto loan, particularly if you have a relationship with them already. Your primary bank may be able to offer you a loan with a lower APR than you could get elsewhere, although it really depends.
Pros of getting an auto loan from a bank or credit union include:
- Lower interest rates — “Credit unions and banks can offer much lower rates, which can be a good deal in terms of saving money,” says Olsen.
- Forgiveness for a low credit score — “If your credit score is low, a large banking institution has a lot more leeway to lend you the money you need,” says Olsen. And you may not be penalized as much for having a low credit score if you have a long relationship with the bank already.
- Personal touch — Olsen notes that many people turn to banks and credit unions when getting an auto loan because they prefer to interact with a lender in person.
Cons of getting an auto loan from a bank or credit union can include:
- Lack of technology — Small credit unions and banks often lack some of the technology that consumers like — perks like online bill-pay, automatic payments or online account management.
- Higher interest rates at banks — Olsen says credit unions tend to offer lower APRs than banks. “But you should definitely shop around,” he says.
Online auto lenders
Online institutions may offer less of a personal touch, but their loan offerings are similar to those from brick-and-mortar institutions. Thanks to new technology and the internet, it’s possible to shop around and compare auto loans without ever leaving your home.
Some of the pros of getting an auto loan online include:
- Convenience — “The consumer can benefit from the convenience of being able to shop around and get several rates in one place,” says Olsen. Further, shopping around online is a good deal whether you decide to go with a bank or not. “It gives you an idea of what you qualify for,” he says.
- Price — Depending on your credit score and loan offers available, you may qualify for a lower APR and better loan terms with an online lender.
Cons of getting an auto loan online include:
- Sharing personal data online — “You need to give up your personal data online, which you may not be comfortable with,” says Olsen. Keep in mind, however, that you can often get a preliminary auto loan offer without giving your Social Security number or other personal data.
- No personal touch — Getting a loan online is impersonal and some people crave the personal connection you get with a brick-and-mortar institution.
Applying for financing from a car dealership is popular among auto buyers who purchase both new and used cars. With dealership financing, you can complete your entire auto purchase all in one place.
Pros of dealer financing include:
- Special promotions — Olsen says dealerships often have special promotions to get you to use their financing. On new cars especially, you may qualify for 0 percent intro APR or low interest financing, along with special rebates or discounts.
- Convenience — Many buyers opt for dealership financing because it’s convenient to buy their car and get a loan all in one place.
Cons of dealership financing include:
- Lack of options — While some dealerships may offer several loan options to choose from, you may be at a disadvantage if you don’t compare loan offers elsewhere beforehand. Olsen says it’s easy to assume dealership financing is a good deal when you don’t know what else is out there.
- Added costs — Olsen says that many dealerships get a “kickback” from lenders when they get consumers to use certain types of financing. As a result, their loans may come with higher APRs and more added costs, specifically on used cars.
Home equity loans
Home equity loans let you borrow a fixed amount of money against the equity you have in your home. If your property is worth $300,000 and you only owe $150,000, for example, a home equity loan could let you borrow against part of your $150,000 in equity. Home equity loans are fixed-rate installment loans, meaning you pay the same APR and monthly payment throughout the life of the loan.
Pros of using a home equity loan to buy a car include:
- Negotiation power — With a home equity loan, you would get access to cash you can use to buy a car. “As a cash buyer, you may have more room to negotiate the price of a car,” says Olsen.
- Tax incentives — You may be able to write off the interest on your home equity loan if you itemize your taxes, and you cannot write off the interest on an auto loan. “Definitely consult with a tax professional before you consider this option,” says Olsen.
Cons of using a home equity loan:
- Higher rates — If you can’t qualify for a low rate on an auto loan but have a lot of equity in your home, a home equity loan may help you secure a lower rate. But Olsen says this isn’t always the case: “Auto rates are so low that I can’t imagine a home equity loan would be a better deal.” Definitely compare rates to see which is the best solution for you.
- Using your home as collateral — “Using a home equity loan to buy a car means putting your home down as collateral to borrow for a depreciating asset,” says Olsen, adding that this option is “risky and unnecessary.”
- You may not get a better rate — “The auto market is so competitive that rates are very low,” says Olsen. Buyers should try to take advantage and keep their home and auto purchases separate, he says.
If you’re having trouble getting an auto loan for any reason, you may consider turning to family members or friends for help. With a personal loan from someone you know, you could get into the car you need faster and without all the red tape. But, is borrowing money from family and friends a good idea? Maybe, but not always, says Olsen.
Pros of getting a loan from family or friends include:
- More options — If you can’t qualify for a traditional auto loan due to poor credit, your family or friends might lend you money anyway.
- Potentially better rates — Your family might loan you money for lower rates than you could qualify for elsewhere, particularly if you have bad credit.
Cons of borrowing from family and friends:
- Awkward situations — Your relationship with family or friends could easily sour if you don’t repay the loan.
- You’re not building credit — As Olsen points out, loans from family don’t let you build credit since they don’t report to the three major credit reporting agencies: Experian, Equifax, and TransUnion.
Where to compare auto loan rates
While you may want to apply for dealer financing in certain situations, it’s always smart to compare auto loan rates ahead of time, and definitely before you head out to a dealership. By checking rates ahead of time, you can gauge the market and what you may be able to qualify for in terms of APR.
One of the easiest ways to research auto loan rates is to check out LendingTree’s auto loan comparison tool. Here, you can compare loans based on the type of financing (new car, used car or auto refinancing), loan term, make and model of car, mileage, employment status and income. Not only is this resource free to use, but it’s easy to navigate.
Financing a new car works similarly to financing a used car, says Olsen. In both cases, you’re applying for a loan to cover the price of the car then agreeing to make monthly payments until the loan term ends.
Still, there are several differences that can vary depending on the purchase. Those differences can include:
Price — Olsen says one of the biggest differences in financing a new or used car is price, and statistics seem to agree. The fact that pricing is different doesn’t change the loan process, however. “You’re just spending more on a new car,” says Olsen.
Value assessment — Olsen says it’s easier to figure out what a new car is worth whereas determining the value of a used car is a more complex process. “If you’re buying a used car, you need to take time to figure out the real value of the car before you negotiate,” he says. “You need to know the car has a clear title, the condition, has it been in a wreck, the mileage, and other factors to make a fair offer.”
Olsen says Kelley Blue Book is a great resource for finding your car’s value.
Interest rates — Olsen says you typically need to pay a higher interest rate on used cars, and you may even pay a higher rate if the car you’re buying is in less-than-perfect condition.
Depreciation — Research shows that new cars depreciate a lot faster than used cars. Before you buy a used car, make sure you know how much it will be worth in the future — especially if you plan to sell within a few years.
While these differences may be notable for any buyer, Olsen says it’s important to know your options before you buy any car.
“Whatever car you buy, new or used, make sure to shop around, figure out what you can afford, and get the best deal possible on financing,” he says.
The following table shows how buying and financing a new or used car might look in terms of price, long-term costs and depreciation:
|Financing a New vs. Used Car|
|New car||Used Car|
|Average cost||$34,968 (January 2017)||$19,189 (2016)|
|Average Payment||$663 per month for 60 months (rounded)||$399 per month for 60 months (rounded)|
|Expected Depreciation||Edmunds reports that an average midsize sedan priced at $27,660 can lose up to $7,419 in value the first year.||Edmunds reports that, for years two, three, and four, the same car would only average $5,976 in depreciation total.|
|Total loan cost||$39,786 (rounded)||$23,911 (rounded)|
If you’re angling for a new car but aren’t sure you want to deal with the upfront depreciation or high price point, another option to consider is leasing a car. When you lease a car, you agree to pay a set monthly payment to drive the car for a predetermined length of time. The difference is, you must return the car when your lease offer is over unless you choose to exercise an option to purchase.
While leasing can be a good idea if you want to drive a new car without the commitment, there are notable downsides to consider with leasing, too. The following table can help you determine which is better — buying or leasing?
|Leasing vs. Financing|
|Leasing a car||Financing a car|
|How does it work?||With a lease, you pay a set monthly payment until your lease is over. However, you never own the car.||When you finance a car, you agree to the terms of a loan then make set monthly payments until your car is paid off.|
|Who owns the car?||With a lease, the dealership owns the car the entire time.||Once your car is paid off, you will receive the title and own your vehicle.|
|Which is cheaper?||The Consumer Financial Protection Bureau (CFPB) notes that leasing tends to be less expensive than financing a car. If you go over your mileage limit, however, it can become very costly.||Buying a car may be costlier in the long run. However, you can potentially own the car yourself.|
|Can I get out of this agreement?||When you lease a car, you may be subject to early-termination fees if you end the lease early.||When you buy a car, you can trade it in or sell it in any time. However, some car loans come with prepayment penalties if you pay off your loan early. If you sell your car quickly after buying, you may also owe more than your car is worth.|
|How long does it last?||The CFPB reports that most leases last 2-4 years.||Experian reports that the average new loan term is at nearly 69 months, or five years and nine months.|
|Can I drive as much as I want?||Many leases limit the number of miles you can put on the car, with an average limit of 10,000-15,000 miles per year. The CFPB reports that most leases impose extra fees for excess mileage or excessive wear and tear.||When you finance a car, you can drive as much as you want without penalty.|
What about those “no credit, bad credit, no problem!” dealers?
Some dealerships offer in-house financing to people with poor or no credit. While these dealerships may be a suitable option if you need transportation in an emergency, they offer higher interest rates than you could get with a bank or online lender. If “buy here, pay here” is your only option, “you may want to consider whether the cost of the loan outweighs the benefit of buying the vehicle,” notes the CFPB.
What is the best way to find out how good your credit is?
You can get a free copy of your credit reports annually from AnnualCreditReport.com. Several websites such as LendingTree also make it possible to get a free estimate of your credit score.
What is a cosigner?
If you have poor credit, you may be asked to get a cosigner for your car loan. This person will take out a car loan with you, making themselves mutually and individually responsible for the repayment of your loan.
What is the best way to reduce the amount of a car loan?
The best ways to reduce the amount of your car loan (and monthly payment) are saving up a large down payment, buying a less expensive car and choosing a vehicle with fewer features.
Should you get preapproved for an auto loan?
Getting preapproved by a lender for an auto loan up to a certain amount is a good way to start your search for a new or used car. Having a preapproval letter in hand may even put you in a better bargaining position with a dealership.
Will shopping around for auto loans hurt my credit?
Shopping around for the best loan will have minimal impact on your credit report, if any. The benefit of shopping around and getting a lower rate will far outweigh any downsides. To minimize the impact of hard inquiries on your credit report, try to do all of your loan shopping within a period of 14-45 days.