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Auto Loans: New & Used Car Financing Options

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You need a car and don’t have the cash to buy it outright, but the thought of financing a car loan has your wheels spinning. There are so many options, types of loans, loan term length vs. interest rate. Then there’s the dilemma of whether a new or used car is a better deal.

If you’re on a tight budget, you may wonder if you can even get a car loan.

Making a monthly car payment is a major commitment, but for many people it’s the only option- — 85% of new car buyers and 37.5% of those buying used, finance the purchase.

Considering the monthly financial commitment, keep in mind that when you shop for a car, you’re also shopping for financing. In fact, you likely should shop for financing you can afford, then find a car that fits the bill.

Understanding how car loans work, the different types of loans and what they mean for your pocketbook will put you in the driver’s seat.

How Do Car Loans Work?

A car loan is a secured loan, meaning it uses collateral, in this case your car, to guarantee payment. If you miss a certain number of payments, the car will be repossessed. If you make the effort to get it back, it will end up costing you a lot more money in fees than just the back payments.

Car loans are also fixed loans, which means the payments are for a specific amount of time, with options ranging from 24 to 84 months. The interest and payment stay the same for the life of the loan.

While the payment is lower on a loan with a longer repayment period, you end up paying more in the long run, because the interest rate is higher. A loan of seven years (84 months), or the more common five years (60 months), may fit well with your monthly budget, but remember that you’ll be making those payments for 5-to-7, and that’s going to cost a lot of extra money in the long run. Also, you don’t want the loan to outlive the car. Bite the bullet and go for the shortest term you can afford.

In 2020, the average new car loan was a record $34,635, with a $563 average monthly payment, according to Lending Tree. The average used car loan was $21,438, with a $397 payment. Car loan interest rates fluctuate, but generally hover around 3.9% to 4.6% for people with excellent credit, depending on the length of the loan. If your credit score is lower than 660, you can pay a lot more, and it can rise to as much as 22.66% interest if your score is 500 or lower.

Car dealers offer their own financing, and while it’s tempting to jump at it, shopping around for financing is just as important, maybe more important, as finding a car you like.

Can You Refinance a Car Loan?

If you’re in desperate need of a car and can’t shop around, or if your credit is bad, so you have to get a loan with high interest, you can refinance it down the line. This is especially true if your income or credit score improves. So, shop around for refinancing options to shorten the loan term, get a lower interest rate, or both. Your local bank or credit union are good options. There are also a variety of options online. Credit score and payment history will be factors in how good a deal you get, no matter who you go with.

Car Loan Comparison

When you shop for a car, the number to pay the closest attention to is the total payment. That goes way beyond the sticker price. It’s the loan amount plus the taxes, title, fees and interest — how much you’ll pay a month. Keep in mind you want to balance the shortest possible loan term with a monthly payment that you can afford.

Let’s say you’re looking to buy a new car for about $20,000 and want to pay less than $300 a month. You might think about taking out a six-year loan so you can “buy more car,” but look at the chart below. The total payment of a six-year loan turns that $20,000 car into a $25.500 car.

So, then you decide on a four-year loan. But as the chart shows, that means a monthly payment more than $100 a month higher, you can’t afford that.

The last box in the chart shows how much it would cost if you bought a $15,000 car instead of one for $20,000. You would still have a monthly payment you could afford (less than $300) and save $2,000 in interest payments.

So, the lesson here is, don’t compare makes and models, compare loans and how much it will cost you to get a payment you can afford, then find a car you like that fits the number.

Total Auto Loan Cost
Term4 Years (48 months)5 Years (60 months)6 Years (72 months)4 Years (48 months)
Listed Price$20,000$20,000$20,000$15,000
Taxes, Title and Fees$2,000$2,000$2,000$1,700
Down payment$4,000$4,000$4,000$3,000
Loan Amount$16,000$16,000$16,000$12,000
Interest Rate (APR)7.02%7.02%7.02%7.02%
Total Interest$2,397$3,017$3,651$1,797
Monthly Payment$383$317$273$287
Total Payment$24,397$25,017$25,651$18,497

New vs. Used Car

Loans for new and used cars have similar terms. But it’s important to look under the hood and see what you’re really getting. A new car loses 10% of its value as soon as you drive it off the lot. It loses another 10% after a year. That means 20% of the car’s value of your car is gone in the first 12 months. That’s why experts tell you it’s best to buy a car that’s at least a year old and let someone else take the 20% depreciation hit.

The graphic below shows how much you can save by buying an older version of the same model of car. This example is a 2021 Subaru Outback, basic edition, that has a $27,845 MSRP – manufacturers suggested retail price. You can get a 2020 certified pre-owned (CPO) version of the same model, a one-year-old car with all that depreciation taken care of, for $26,363, saving $1,503. By a two-year-old model and the savings really begin to show. The CPO is $4,399 less than the new one.

A CPO has been inspected, refurbished and certified by the manufacturer that it is in good condition. Typically, they also come with an extended warranty and similar perks you would find on new cars like special financing offers and other benefits.

If you bought the 2020 Subaru Outback “used,” meaning from a guy across town or from a dealer not associated with the manufacturer, you’re taking a chance, but saving even more.

Total Auto Loan Cost
Certified Pre-OwnedUsed
Model YearList PriceSavingsList PriceSavings
2020 (1-year-old)$26,363$1,503$24,382$3,503
2019 (2-year-old)$23,086$4,399$20,279$7,206
2018 (3-year-old)$20,266$7,579$18,167$9,678
2017 (4-year-old)$17,954$9,891$15,817$12,028
2016 (5-year-old)$15,562$12,283$14,396$13,449

Source: Kelly Blue Book

Go back a few years on a good-quality brand, and you can save serious money buying a CPO from a dealer, or a used car in a private sale. If you’re not car savvy, or don’t have a trusted mechanic, the better bet is the CPO. You don’t want to be loaded down with repair costs that you didn’t anticipate.

But the bottom line is, buying a car only a few years old can really help your bottom line.

New Car Loan vs. Used Car Loan

The biggest difference in a new car loan vs. used car loan is the amount of money you’ll be borrowing. Used cars cost less, which means you can get a shorter term loan you can afford, and spend less money in the long run. Look again at the 72-month loan for a new $20,000 car compared to the 24-month-loan for a 48-month loan on a $15,000 two-year-old car. Both have similar monthly payments, but what looks like a $5,000 savings on the used car is actually more than $7,000 when you factor in the total payment.

New vs Used Car Loans
New Car2-Year-Old Car
Price$20,000$15,000
Loan Term6 Years4 Years
Monthly Payment$273$287
Total Payment$25,651$18,497
Value At End of Term$7,218$8,202
Net Loss$18,433$10,295

If you figure in the depreciation, after you pay off the new car in six years it will be worth $7,218, a net loss of $18,433. The $15,000 car is actually worth more, at $8,202, after four years, a net loss of $10,295.

That $7,000 difference just turned into more than an $8,000 difference. The decision comes down to whether you would pay an extra $8,138 and carry the debt for another two years to drive a new car. Or drive a two-year-old certified preowned vehicle and stash the extra money for a rainy day.

Things to Consider Before Financing a Car

If it’s not already obvious, there is a lot to consider before financing a car. If you have poor credit, the list gets even longer and the options fewer.

Before making the decision to finance, consider all the factors and how they work for you. Important things to consider include interest rates, loan terms, credit pulls, rate shopping, gap insurance, taxes and fees.

Factors to consider:

  • Interest rate. This depends on the term of the loan, type of car and your credit score.
  • Loan terms. It can range from 24 to 84 months.
  • Credit pull. The financing agent may do a “soft pull,” for pre-approval, which doesn’t affect your credit score, but when you apply for the loan, they will do a “hard pull,” which is a complete credit check, which initially takes points off your score.
  • Rate shopping. Apply for pre-approval from several lenders to see the rate options.
  • Some lenders only work with specific dealerships.
  • Down payment. Money you put toward buying the car that you don’t finance. The bigger down payment, the less you have to borrow.
  • Gap insurance. Insurance you buy from a dealer or bank that closed the gap between what you owe on the car and what the primary insurer thinks it’s worth.
  • Funding: An offer for the maximum loan you can get at the best interest rate. It can go right into your bank account or be a certificate that goes to the dealer.

No matter what your financial situation, the goal should be to pay the lowest amount possible over the term of the loan. One common mantra is that a car isn’t an investment. Keep that in mind. An investment makes you money. A car costs you money. You want to be in the best position possible, particularly if you’re on a tight budget.

Everyone’s situation is different, so the elements factor in differently, but don’t go with a super-low monthly payment if you can find a way to pay more. Most people keep a car between five and seven years, and the average life of a car is about 11 years. Those numbers are especially important if you’ve financed a used car, even a certified pre-owned ones. You don’t want the loan to outlive the car, or to pay for gap insurance, adding to your costs.

Keep in mind, too, that if you don’t get a great rate to start with, improving your credit by making payments on time will boost your credit score, and you can eventually refinance.

Budget for a Monthly Payment

Figuring out the financing before you visit dealers includes calculating your monthly budget, and figuring out how much of it can go to a car payment without short-changing necessities like housing, food, an emergency fund and retirement savings.

The 20-4-10 rule is a good place to start on what to pay for a car. It means a 20% down payment, four-year loan term and vehicle expenses like the monthly payment, car insurance, gas and maintenance no more than 10% of your gross income.

Don’t forget to budget car insurance payments. The more expensive the car, the higher the insurance. Most states require a certain level of insurance in order to register the car. If you finance a car payment, in some states the lender will pay for collision insurance for the life of the loan, but they’ll charge you for it.

Also, keep in mind that 27 states charge vehicle excise tax, paid yearly, based on the car’s value.

Is It Worth it to Trade in an Old Car?

If you have a car to trade in, even if it’s not in the best shape, it can help lower the overall cost. There can even be a tax benefit — if you trade it in, in most states, you only pay taxes on the difference between the trade-in and the car you buy. If you sell your old car, you pay taxes on the proceeds.

On the other hand, you could lose money on a trade-in. If a dealer will give you $2,000 on a trade-in, but you can sell the car for $3,000, it may be worth the tax hit. Know your car’s value by checking Kelly Blue book.

Get a Copy of Your Credit Score and Report

Before you start looking for a loan, check your credit score and credit report.

You can get your credit score free from several online sites. The score may not be the exact same score a lender uses, but it will be close.

Each of the three credit bureaus (TransUnion, Experian and Equifax) are required to provide one free credit report each year.

Look for any errors, outdated or false information, and dispute them. A quick way to improve your credit score – and get a better interest rate on a car loan – is to lower your credit utilization. That is the ratio of your credit card balance to your available credit. The less available credit you use, the better your score, so be sure to keep credit utilization below 30%. One quick and easy fix is to pay off your credit cards twice a month instead of at the end of your billing cycle.

Let’s see how your credit score affects the interest rate you’ll be charged. Let’s assume you’re buying a $20,000 car with a 20% down payment, so you need a $16,000 loan over four years.

Here is what the average car loan interest rate by credit score looks like:

Credit Score vs Loan Interest
FICO ScoreInterest (APR)Monthly PaymentTotal Interest Paid
720-8503.88%$360$1,300
690-7195.233%$370$1,768
660-6897.353%$386$2,517
620-65910.344%$408$3,606
590-61914.86%$444$5,320
500-58915.83%$452$5,699

Source: myFICO

The graph demonstrates the impact your FICO Score, the most widely used credit score, has on your interest rate, monthly payment and total cost. The exact same car can cost thousands of dollars more depending on your credit score.

Shop for Financing

You have two options for financing a car: direct lending or dealership financing.

Shop around for direct lenders like credit unions or banks and get pre-approved for an auto loan.  Be sure to work with a trusted lender, and keep an eye out for predatory lenders who look to take advantage of people who are desperate for a car loan.

Once you have an offer, bring it with you when you shop for a car. It might not be the financing you end up with, but it will be a big help as you negotiate terms with dealers. It lets them know that you’re aware you can get financing from someone other than them.

Here is a look at some of the lenders available and the types of car loans they offer.

Dealership Financing

Car dealers can sweeten the deal with discounts like taking money off the list price if you finance with them. If you don’t have to borrow as much, obviously it will cost you less. But make sure that a lower price doesn’t come with a higher term or interest rate that will make the sticker price savings pointless.

There are a few different types of dealership financing:

Captive Finance Companies

Many of the major auto makers, like Ford, GM, Toyota and Honda, have a financing arm. These are called captive finance companies, which account for 31% of auto loans and 61.2% of new car loans They can make deals with promotions like 0% interest for a certain number of months or rebates (often called cash bonuses). However, those incentives are usually reserved for customers with excellent credit, so polish that credit score before you go shopping.

Dealer-Arranged Financing

These dealerships have relationships with banks that allow them to provide financing, but they don’t issue loans themselves. Instead, they act as a go-between with customers and banks. Dealerships take a loan from the bank and tack on a few percentages points to the interest for themselves.

Buy Here, Pay Here

There’s a reason only 7.6% of loans are issued by Buy Here Pay Here (BHPH) dealerships. These types of loans are in-house financing, and the house definitely wins. BHPH dealers are notorious for offering high interest loans to subprime borrowers. They’re willing to do this because the loans are secured by the vehicle. When the customer can’t afford to make payments, the dealer will repossess the car, sell it again and collect another down payment. 

Banks

Banks have always accounted for one of the largest shares of auto loans, competing with captive lenders for the top spot and make up 30.2% of the market. Historically, they were the biggest lender, but since the Great Recession, banks have been more reluctant to issue car loans. It a big reason why captive finance companies have become so popular. Still, banks are a good place to get pre-approved as a reference point.

Credit Unions

Credit unions make up 18.7% of the auto loan market for a good reason: they are nonprofit institutions, which means they can offer lower rates than banks. A typical rate on an auto loan from a credit union is about 1.25% less than what a bank can offer. The catch is that not all credit unions lend to borrowers who aren’t members. Navy Federal Credit Union and Alliant Credit Union are two of the more popular credit unions. It’s a good idea to check and see if you qualify to become a member of a credit union when shopping for auto financing.

Online Lenders

LendingTree, MyAutoLoan and Clearlane (a branch of Ally Financial) are three of a variety of online services that collect a number of loan offers from different lenders so that you can easily make comparisons. LightStream (offered by SunTrust) issues online loans to customers with excellent credit, and Auto Credit Express does the same for those with poor credit.

Consumer Finance Companies

Be wary of consumer finance companies like Westlake Financial, Credit Acceptance Corp and Santander. These types of companies have been in the news for shady business practices like illegal repossession and bating customers into loans with extremely high interest rates. Their popularity is rising, and they account for 12.4% of loans.

Home Equity Loan to Pay for a Car

One alternative financing option that could be appealing to a homeowner is taking a home equity loan to pay for a new car. The rates on home equity loans should be close to what you would pay for an auto loan.

Taking Out a Personal Loan to Pay for a Car

Taking out a personal loan to pay for a car is not a bad idea if you can afford to pay over the likely shorter term of a personal loan. Generally, you need a credit score of 660 or higher to get an unsecured personal loan.

The benefits of getting one to buy a car are that, if you’re buying a used car from a private seller, it’s way to get the money more quickly. The car isn’t collateral for the loan, so you’re in less danger of losing it if you can’t pay.

But if you’re on a tight budget or have bad credit, this isn’t an option that will likely be available to you, or be one you can afford.

Car Loan with Bad Credit

People with bad credit can still buy a new car, but it’s not easy and will cost more money than is worthwhile.

Lenders are at considerable risk making car loans to people with bad credit or no credit, so they take as many steps as possible to minimize that risk. It is not unusual for them to ask for a substantial down payment and charge an interest rate at least 10 points higher than what they’d charge someone with good credit.

This allows the banks to get closer to break even if the borrower defaults on the loan. They also can seize the car and sell it to someone else to recoup some of the loss if the borrow defaults.

A borrower with bad credit does has financing choices, though. If possible, start with a clean record, paying off any outstanding car loans and other debts before shopping for a new car. That improves your credit score and increases your options. Another option is a shorter loan term. Although the average car loan is 72 months or longer, a 48-month term will mean a lower interest rate.

If possible, save up for a large down payment. If you can cover at least 20-30% of the cost with money down, and take advantage of any dealer incentives and rebates when buying the car, you can avoid being in an upside-down position when financing the car. You may still have to pay double-digit interest rates at the start of a loan, depending on your credit score, but two or three years down the road, when your credit has improved, you can refinance the loan.

The best option, especially if you have poor or no credit, is to buy a used car. As we saw earlier, they cost less. And the interest rates on financing a late model car should be similar, if not exactly the same, as buying a new car.

After Signing

Once you decide to buy a car, be sure the terms are final and that your financing is fully approved before you sign the contract and drive the car off the lot. If it isn’t final, tell them you’ll come back the next day. Don’t leave without a copy of the agreement. You want to be sure the deal you sign for is the deal you were promised.

The lender is the legal owner of the car, which means they hold a lien on it, in some cases hold the title too, until you pay off the loan. If you default, the lender has the right to repossess the car. So, make your payments on time, and at the end of the loan term, the car lien will be released to you.

Is Financing a Car a Good Idea?

Only you know whether financing a car is a good idea for you. It depends on your financial situation and how the risks and benefits discussed in this article relate to it.

Even if you have the money on hand to pay outright, if it’s going to mean not paying other bills, or taking money out of your emergency or retirement account, financing is a better decision.

The best way to look at it is to consider what you can afford, within your budget, including the shortest term, and make a down payment if you can afford it. Determine your financing before you decide on a car.

Dealers offer a lot of specials, particularly around holidays, and it’s a good idea to research those and see if the special financing terms can fit with your financial needs. Keep in mind that dealers usually require you to finance through them to get the deal.

If you want to get your financial situation in better order by managing your credit, you may want to consider a nonprofit credit counselor. There are many nonprofit debt counseling and debt management companies available to help you evaluate your debt load, and they may suggest a debt management plan that would pay down your debt. Be sure the nonprofit credit counseling agency you choose has a good track record with consumers. It should present you with a plan that lowers your credit card interest rates and monthly payment. The process takes 3-5 years, and if you need a car now, it may not offer immediate relief. But once you buy a car, it could help you manager your debt so you could eventually refinance. There is a monthly service fee involved, which should be considered.

Maureen Milliken has been writing about finance, banking, investment, entrepreneurship, real estate and other related topics for more than 30 years. She started as the “Business Beat” columnist for the now-defunct Haverhill (Mass.) Gazette and currently is one of the hosts of the Mainebiz business-focused podcast, “The Day that Changed Everything” in addition to her daily writing. She also is is the author of three mystery novels and two nonfiction books.

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