Most people today need a loan when they buy a new or used car and the high cost of many vehicles often means that consumers spend years paying off the auto loan. The average length of a car loan at the start of 2015 was 67 months, about five months longer than it was in 2010.
The trend is going even longer with 30% of car loans now stretched between 72 and 84 months. The average amount financed in 2015 was $28,711 with average monthly payments of $485, a record high for both length of loan and amount financed.
Types of Auto Loans
Not all car loans are alike. The most common types of car loans include:
- Simple Interest Loans are the most common type of auto financing available. The interest rate is based on the outstanding balance of the loan. Borrowers can save on interest costs by paying more than their standard
- Pre-Computed Loans refer to financing where all interest and principal payments are pre-calculated before the borrower and lender agree and sign the paperwork. Although this loan was widely used in the past, most people don’t opt for this restrictive method of financing because it doesn’t allow for early repayment of the loan.
Much more risky is borrowing money based on equity in the car you already own. These car title loans mostly appeal to people who have fallen on hard times and need cash they cannot borrow elsewhere. Interest rates on these short-term loans can be sky-high, and a borrower who fails to pay can find himself deeper in debt and at risk of losing his car.
Now that you understand the various loan options available for purchasing a car, buyers have a number of potential sources for securing the necessary financing.
The most common places to secure auto loans are:
- Banks. Getting financed through a bank is typically the easiest route because commercial and private banks have large pools of capital. A bank could be your best bet if you are looking for the lowest interest rate. Banks can also be a quicker and more convenient source for car loans because they are structured to make a large number of transactions in a short period of time.
- Credit Unions. These nonprofit organizations can offer competitive interest rates, but you need to be a member to utilize their services. Criteria for membership varies, but credit unions may focus on people who work in specific industries, live in a certain area or belong to a particular group.
- Car Dealerships. Car dealerships offer financing to help sell cars. They often have established relationships with lenders, which can help you get a loan quickly and without a lot of legwork on your part. Keep in mind, however, that dealers typically make a considerable profit on loans, so it pays to understand the interest rate and other terms being offered.
- Home Equity Loans. These are an alternative to a traditional auto loan. Financial institutions often lend money to borrowers based on the equity in their homes, called a home equity loan. This money can be used for many purposes but a popular one with many borrowers is buying a new or used vehicle. One particularly attractive feature is that interest on these loans is typically tax-deductible.
How Does Car Loan Interest Work?
The typical automobile loan is calculated using simple interest, meaning you pay interest only on the principal owed.
This is similar to the method used in repaying mortgages and student loans, but vastly different from the method used with credit cards, where compound interest creates a much larger bill for the borrower.
For example, a simple interest automobile loan of $18,000 at an interest rate of 9.9 percent (typical in 2015 for someone with credit score of 640) would mean monthly payments of $332.55 and cost $23,944 when the loan is paid off.
Compare that to the same loan, using compound interest. The $18,000 loan would end up costing $32,522. Interest payments alone would be $14,523. That is why credit card debt builds so rapidly and why you should insist on a simple interest loan when buying a car.
Car Loan Rate Tied To Credit Score
Your credit score determines how much of the car a lender is willing to finance. You probably have heard advertisements for “zero percent interest” from dealers. They do exist, but you must have a credit score of 750 or higher to get them.
If you have bad credit (such as a credit score under 550), the best you can hope for is they will finance 80% of the car’s value and you will have to make up the remaining 20% with a down payment.
Credit scores and interest rates operate in a see-saw fashion on auto loans. As your credit score rises, the interest rate you pay drops. If your credit score drops, the interest rate goes up.
For example, in 2015, a credit score of 740 would get you a 72-month loan at 2.9%. A credit score 100 points lower (640) and you’ll be paying 9.9%. Drop another 20 points to 620 and the rate goes up to 12.49%.
To put that in dollar terms, if you finance $18,000 for the car, the difference between a very good credit score (740) and an average score (640) is $4,311 over the life of the loan. The difference between the very good and poor score (620) is $6,035 over the course of six years.
Car Loan With Bad Credit
It is not impossible to buy a new car with bad credit, but lending institution can make it very difficult and definitely expensive.
Lenders know they are at considerable risk by making car loans to people with bad credit or no credit so they take as many steps as possible to minimize the danger. It is not unusual for them to ask for a substantial down payment and charge an interest rate that is at least 10 points higher than someone with good credit pays.
This allows the banks to get closer to break even if the borrower defaults on the loan two or three years after purchase. A car loan is a secured, which means the vehicle serves as collateral on the debt. If you fail to make your payments, the lender can seize it as payment. This is much safer for the lender than unsecured debt, such as a credit card account, where the lender has only the card-holder’s promise to pay.
A borrower with bad credit has some financing choices, but they are limited. The borrower’s best recourse is to start with a clean record, meaning pay off any outstanding car loans and other debts before shopping for a new car. That not only improves your credit score, it allows time to save up a down payment. Another option is a shorter loan term. Although the average car loan is 72 months or longer, ask for a 48-month term and the interest rate will drop by a percentage point or two.
The next possible option is to save until you have a large down payment. If you can cover at least 20-30 percent of the cost with a down payment and take advantage of any dealer incentives and rebates when buying the car, you help 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, you can look for an opportunity to refinance the loan when your credit score has improved.
If you have poor or no credit you should also consider purchasing a used car that is 1-to-3 years old. You would enjoy a sizeable reduction in price, which means borrowing less and paying less interest in the process. The good news is that interest rates on financing a late model car should be similar, if not exactly the same, as purchasing the car new.
Negotiating A Better Car Deal
There may be room to negotiate the final price of the car, but there is little or no room to bargain when it comes to financing the car.
Smart buyers know their credit score before they start looking for a car and use that information to get pre-approved for a loan from their bank or credit union.
When you decide the car model you want to buy, it’s possible to take the terms from your bank into the dealership and ask them to beat it, but only if your credit score supports it.
Most dealerships have relationships of their own with banks and credit unions, but use a customer’s credit score as the measuring stick for what interest rate to charge on the loan. It’s possible there might be a light difference, but seldom enough to change a deal.
What About Leasing?
As car costs have risen, leasing has become a popular alternative to buying. In recent years, leases have comprised more than 30% of new vehicle transactions.
On the surface, leasing and buying with a loan may look similar. Both involve payments over time, but what you are buying is different.
With a car loan, you eventually will pay off the loan and own the car. Your payments end and you have the option of keeping the car as long as you like — or as long as you can keep it running – or selling it.
With a lease, you likely will have a lower down payment, lower monthly payments and lower maintenance costs compared to taking out an auto loan. This is part of the appeal of a lease.
However, at the end of the lease you do not own the car. At this point you have two options: buy the vehicle, which can require taking out a loan, or begin a whole new lease