Before you take out a car loan, it's important to understand what you're agreeing to, how your credit will affect your loan experience, and how an auto loan can influence your credit and overall finances. For many consumers, casually stopping by their local auto mall can turn into a big purchase with many researching their vehicle preferences with less attention towards the financing. Shopping around for an auto loan before taking a step into a dealership could significantly save money and even get you more car for your money.
Buying a car is likely to be one of the biggest purchases you will make, after buying a home, with average new car costs exceeding $30,000 and average used car costs reaching as high as $18,000. In 2016 alone, total auto loan balances grew by 8.6% over the previous year and exceeded $1 trillion.
Determine How Much Car You Can Afford
Most people don't have the cash required to buy a vehicle without financing, which is why when they're considering the cost of a car, the total monthly expense is as important as the total price tag.
To determine how much car you can afford, consider the total monthly costs, including car loan payments, insurance, gas and maintenance. You also need to consider other monthly debt obligations you may have, such as credit cards, student loans and a mortgage.
The total amount of debt you have, compared to your income, is called your debt-to-income ratio, and it can be a factor in whether lenders agree to give you additional credit. Generally, a ratio below 40% is considered good. If your monthly gross income is $4,000, then your monthly debt expenses should be less than $1,600.
Credit Scores and Buying a Car
Before making a major purchase, it's a good idea to check your credit report and credit scores at least three to six months prior to your planned purchase.
The credit score needed to qualify for a loan will vary depending on the lender, since they will each have different criteria to grant you a loan and may use different credit scoring models, such as the FICO Auto Score 8, which has a score range between 250 and 900.
Also, there are lenders that specialize in approving loans for those with lower credit scores. These can come with higher interest rates and less favorable terms. For example, if you wanted to purchase a car for $30,000 with a five year term, the interest rate could be 11%. After the five year period, you would have to pay $9,140 in total interest. With the same loan amount and term length, but with an interest rate of 4%, the total amount of interest paid would be $3,150 or just over a third of what you would pay at the higher rate.
Applying for the Car Loan
When you secure a car loan, the lender agrees to loan you the purchase price of the vehicle, and you'll agree to repay that principle with interest over a set period of months. It's important to understand that the finance company technically owns the car until you pay off the loan.
As you're applying for a car loan, you'll encounter some important financial terms, including:
- Down payment — This is the amount of cash you have to put toward the purchase price of the vehicle. The down payment lowers the amount you need to borrow, which in turn lowers the total amount of interest you'll pay over the life of the loan.
- APR (Annual Percentage Rate) — Any type of loan comes with interest, which is basically what the lender charges for allowing you to use their money to make a purchase. Your car loan interest rate and any fees your lender charges make up the APR. When you're comparison shopping for a car loan, comparing APR can be a good way to assess the affordability of different loans.
- Taxes and fees — Every state charges sales tax on vehicles, plus you'll pay fees to register the vehicle. Typically, dealerships will charge a documentation fee to take care of registering the car and securing tags for you. Dealerships could also charge a destination fee from the manufacturer, which is the equalized cost of transporting the a car line across the country.
- Term — The term is the number of months you have to pay back the loan. Some common terms are 36 months to 72 months, with some loans exceeding 72 months. The longer the term of the loan, the more you will pay in total interest for the car. Some lenders will also offer better interest rates for shorter term lengths, such as 36 months, and provide higher rates with longer terms, up to and even beyond 72 months. For example, the interest rate for an auto loan with a term of 36 months could be 4%, whereas an auto loan for 72 months could be 6%.
- Monthly payment — This is the amount you must pay every month to the lender, by an agreed-upon date, to repay the loan. It includes both principle and interest. At the beginning of the loan, your loan agreement will specify your monthly payment and how many payments you must make to fully repay the loan. One reason people take a longer loan term is to secure a lower monthly payment. Because the lender technically owns your car until you fully repay the loan, they can repossess the vehicle if you miss payments.
Shopping Around for Car Loans
Just as you comparison shop for the best price on the vehicle you want to buy, it's important to shop around for the best car loan deal because comparison shopping can help you secure the best interest rates.
When shopping for a car, it is also common for auto dealers to submit applications to multiple lenders to help you find the lowest interest rate and favorable terms. You can also shop around for an auto loan on your own, and keeping those applications within a short period of time will minimize the number of hard inquiries. Every time you apply for credit, it generates a hard inquiry on your credit report, and too many hard inquiries can negatively affect credit scores. Scoring models like FICO usually will group similar hard inquiries that occur in a short time frame, treating them as a single inquiry, which reduces their impact on credit scores.
Multiple sources can provide you with an auto loan, including:
- Banks and credit unions — When you get a loan from a financial institution, it's known as direct lending. With direct lending, you can secure your financing before you go car shopping, so you'll know exactly how much a loan — and the vehicle — will cost you. Once you've found the car you want, you can use the direct loan to purchase the car from the dealer.
- Dealer financing — You can also apply for and secure financing through the dealership where you buy the car. The dealer may hold on to the loan or sell it to a bank, finance company or credit union. Financing through a dealer can be convenient, may provide you with access to special deals and incentives, and may be easier to qualify for than a direct loan.
- Online lenders — A number of online lenders provide auto loans. These loans work similarly to direct lending from a bank or credit union. Some consolidating websites allow you to get quotes from multiple lenders by completing a single online form.
Getting Pre-Approved for a Car Loan
If you decide to get a loan from a bank or credit union, you can get pre-approved. Getting pre-approval for a car loan involves completing a preliminary application with a lender who will review your credit and other financial information. They'll let you know how much of a loan they're willing to give you and the interest rate they're likely to offer.
Pre-approval can help you find the best interest rate, makes it easier to know how much you can spend, and gives you bargaining power with a dealership. It doesn't obligate you or the lender to actually enter into a loan agreement.
Remember to keep your pre-approval and actual loan application within a short time period to minimize the possible impact of hard inquiries on your credit score.
Car Loans for Bad Credit
Ideally, if your credit report contains some negative information, or your credit score is not as high as you would like, you should consider taking steps to improve your credit before applying for an auto loan. Improving your credit can boost your chances of qualifying for an auto loan at a good rate and terms. Improvement steps include:
- Bringing any late payments or collection accounts current.
- Paying all your bills on time every month.
- Paying down existing debt to improve your credit utilization ratio, which compares the total amount of credit you have available with how much of it you're actually using.
If your credit report and scores are poor, and you can't afford to wait to get a car, it may still be possible to get a car loan. However, be aware your loan will likely have a higher interest rate than what's offered to people with good credit scores.
You can offset the impact of poor credit by saving up for a bigger down payment. The down payment will reduce the amount you have to borrow — and the amount of interest you'll pay over the life of the loan. Plus, lenders may view your down payment as evidence you know how to manage money well enough to repay their loan.
You can also ask someone with good credit to co-sign for a car loan. When you have a co-signer, that person's good credit will influence the interest rate and terms the lender offers. However, your co-signer will share responsibility for repaying the loan, so it's important to ensure you make all payments in a timely manner.
Make Loan Payments on Time
Credit scoring models take into account how reliably you pay all your bills, including auto loans. In fact, payment history is the most important factor in determining credit scores. By paying your car loan on time every month, you can help build positive credit history.
What's more, when you finish repaying the loan, the lender will report the account as closed and paid in full to credit bureaus, and will remain on your credit report and benefit your credit for ten years from the closed date. That paid-up loan tells future lenders you know how to manage credit and repay your debts.
However, paying late or missing payments altogether can hurt your credit score and make it harder to get credit in the future. Late or missed payments appear as negative information on credit reports, and remain for seven years. On the positive side, as the late payment becomes ages over time, the less impact it will have on your credit score.
Missing too many payments may cause the lender to turn your debt over to collections or even vehicle repossession. Both collections and repossessions remain on credit reports for seven years from the initial date of delinquency, and can negatively affect credit scores throughout that time.
Making Informed Decisions
A car loan can be a great way to purchase the vehicle you need (and want) while building your credit at the same time. Be sure to comparison shop for the best loan deal, understand all the terms and conditions before you sign for a loan, and repay the loan on time every month.
Before applying for a car loan, take control of your credit by reviewing your free credit report and taking steps to make improvements. And, when you get check your credit scores, your score is accompanied by the factors that are impacting your credit. Once you know your credit standing and what you need to do to improve it, you'll become better informed with what your options and next steps are.