Auto Loan: New & Used Car Loan Options

New & Used Car Loan OptionsBefore you get too excited about the latest, greatest new car you gotta buy, take a deep breath and put away your checkbook, at least for a moment. There’s a lot of work to be done before you run out to the dealership.

When you plan to buy a new car, you’re not only shopping for the car but the financing as well. It’s a pleasant dream to think you’ll pay cash, but the reality is 85% of new car purchases and 53% of used car purchases use a loan.

The Federal Reserve says that 107 million Americans had car loans in 2017 and the average new car loan was for 69 months and a whopping $30,294.

We’ll go over types of loans and the value of buying a new vs. used car, but have this math formula in mind before you go shopping for a car: The real cost of a car is the purchase price + finance charge. So, if you bought a $20,000 car and paid $4,000 to finance it, you really bought a $24,000 car.

In the summer of 2018, the average loan will cost you 4.21% in interest, which historically speaking is fairly cheap (rates were around 9% in 2000). Lenders have relaxed their credit requirements in the last few years, so it’s a good time to borrow money for a car.

Now, let’s see if you can afford it.

Budget for a Monthly Payment

There’s a few things you need to do before you step foot on a dealership. The first is to calculate your monthly budget, and figure out how much money you have left over for a car payment.

The 20-4-10 rule of thumb is a good place to start. It means 20% down payment, 4-year loan term and your vehicle expenses should be no more than 10% of your gross income (including loan payment, insurance, gas and maintenance).

If you’re buying a new car, be prepared for higher insurance payments. It costs more to insure a new $20k car than a used $10k car. You may have dropped collision coverage on your old, used car, but it’s required if you finance a car payment. Otherwise, the lender will buy insurance themselves and add it onto the loan.

Get a Copy of Your Credit Score and Report

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

You can get your credit score free from several online sites. It may not be exactly the same score a lender uses.

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

Look for any errors, and dispute them if there is any outdated or false information. 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 lower your utilization rate the better your score, so be sure to keep that number below 30%. A 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 care with the standard 20% down payment, and need a $16,000 loan over four years.

Here is what the numbers look like:

Credit Score vs Loan Interest
FICO Score Interest (APR) Monthly Payment Total Interest Paid
720-850 3.88% $360 $1,300
690-719 5.233% $370 $1,768
660-689 7.353% $386 $2,517
620-659 10.344% $408 $3,606
590-619 14.86% $444 $5,320
500-589 15.83% $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. Then take your offer with you to shop for a car. It might not be the loan you end up with, but it can be useful in negotiating terms with the dealer, who isn’t the only one that offers financing for cars.

Here is a look at some of the lenders available for auto loans.

Dealership Financing

Car dealers can sweeten the deal with discounts like taking money off the list price if you finance with them. That could make it cheaper if you don’t have to borrow as much, but make sure it isn’t at the cost of extending the loan term and increasing the interest rate. Any money saved upfront with the discount would be lost on the backend with more months of more interest.

There are a few different types of dealership financing:

1. Captive Finance Companies

Many of the major auto makers like Ford, GM, Toyota and FIAT have their own financing arm of the company. These are called captive finance companies, which now account for 30% of auto 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.

2. 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 to the interest for themselves.

3. Buy Here Pay Here

There’s a reason only 6% of loans are issued by Buy Here Pay Here (BHPH) dealerships. These are known as 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, they’ll repossess the car, sell it again and collect another down payment. 

Banks

Banks always have accounted for the largest share of auto loans and still make up 33% of the market, 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 preapproved as a reference point.

Credit Unions

Credit unions make up 21% 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 that aren’t members, although the requirements for becoming a member have been relaxed. Navy Federal Credit Union and Alliant Credit Union are two of the more popular credit unions.

Online Lenders

LendingTree, MyAutoLoan and Clearlane (a branch of Ally Financial) are three 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.

Home Equity Loan to Pay for Car

 One alternative financing option that could be appealing to a home owner 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. The advantage here is that the interest you pay on a home equity loan is tax deductible.

Car Loan Comparison

 When you shop for a car, the number you want to pay the closest attention to is the total payment. That’s the loan amount plus the taxes, title, fees and interest. What you’re looking for is the shortest possible loan term with an affordable monthly payment.

Let’s say you’re looking to buy a new car for about $20k and pay under $300 per month. You might think about taking out a 6-year loan to “buy more car,” but look at the chart below and check out the total payment of a 6-year loan. That $20k car turns into a $25.5k car.

So, you think ‘I’ll get a 4-year loan,’ but as the chart shows, the monthly payment increases by more than a $100 per month and you can’t afford that much more every month.

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

That’s why you shouldn’t be comparing makes and models. You should be comparing loans and how much it actually will cost you to get a payment you can afford.

Total Auto Loan Cost
Term 4 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
Total Auto Loan Cost
4 Years (48 months) $20,000 $2,000 $4,000 $16,000 7.02% $2,397 $383 $24,397
5 Years (60 months) $20,000 $2,000 $4,000 $16,000 7.02% $3,017 $317 $25,017
4 Years (48 months) $20,000 $2,000 $4,000 $16,000 7.02% $3,651 $273 $25,651
4 Years (48 months) $15,000 $1,700 $3,000 $12,000 7.02% $1,797 $287 $18,497

New vs. Used Car

New cars lose 10% of their value as soon as you drive them off the lot. They lose another 10% after one year. That means 20% of the 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 is at least one-year-old car and let someone else take the 20% depreciation hit.

Look at the graphic below to see how much you can save by buying an older version of the same model of car. This example is a Ford Focus Model S that sold new in 2018 for $17,820.

If you walked into the dealer that same day and asked for a 2017 version of the same model car, you could get a certified pre-owned (CPO) version and save $4,402.

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 same 2017 Ford Focus “used,” meaning from a guy across town or from a dealer not associated with the manufacturer, you’re taking a chance, but saving a little more.

Total Auto Loan Cost
Certified Pre-Owned Used
Model Year List Price Savings List Price Savings
2017 (1-year-old) $13,418 $4,402 $12,918 $4,902
2016 (2-year-old) $11,973 $5,847 $11,473 $6,347
2015 (3-year-old) $11,915 $5,905 $11,415 $6,405
2014 (4-year-old) $9,367 $8,453 $8,867 $8,953
2013 (5-year-old) $7,991 $9,829 $7,491 $10,329

Source: Kelly Blue Book

The difference after a year is obvious, but notice that the CPO and “used” car don’t lose much value between year two and three. Also, the difference between buying certified pre-owned (CPO) and used is only $500.

Bottom line is that the bottom line is a lot more attractive on a CPO or used vehicle than a new one, especially if you must borrow money. 

New Car Loan vs. Used Car Loan

So, let’s go back to our 6-year loan for a new $20k model and say we’ll settle for a 2-year-old $15k model on a 4-year loan. Both have similar monthly payments, but what looks like a $5k savings is actually more than $7k when you factor in the total payment.

New vs Used Car Loans
New Car 2-Year-Old Car
Price $20,000 $15,000
Loan Term 6 Years 4 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
New vs Used Car Loans
New Car 2-Year-Old Car
New Car $20,000 6 Years $273 $25,651 $7,218 $18,433
2 Year Old Car $15,000 4 Years $287 $18,497 $8,202 $10,295

Take it a step further and calculate the depreciation. After you pay off the car in six years, the $20k car will be worth $7,218, a net loss of $18,433. The $15k car is actually worth more at $8,202 after four years, a net loss of $10,295.

That $7k difference just turned into more than an $8k difference.

The decision comes down to whether you would pay an extra $8,138 and carry the debt for another two years to drive that new car. Or take a two-year-old certified preowned vehicle and stash the extra money for a rainy day.

Car Loan with Bad Credit

It is not impossible to buy a new car with bad credit, but lending institutions 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 their risk. 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. 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 and try to re-sell it to recoup some of the loss. 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.

After Signing

Once you make a decision to buy a car, be sure the terms are final and 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, and 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.

Be aware that the lender is the legal owner of the car, which means they hold a lien on the vehicle, and 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.

Max Fay

Max Fay is a recent graduate from Florida State University's Communications School. He has written for several newspapers in the state, including the Miami Herald, Orlando Sentinel, Tallahassee Democrat and Florida Times Union. Max can be reached at mfay@debt.org.

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