Auto Loans: New vs. Used Car Financing Options
You’re in dire need of a vehicle but don’t have the cash to buy it outright. The thought of financing a car loan has your wheels spinning. There are 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- — 81.98% of new car buyers and 40.44% of those buying used financing to make the purchase in 2022.
Considering the monthly financial commitment, keep in mind that when you shop for a car, you’re also shopping for financing. You should shop for financing you can afford, then find a vehicle that fits the bill.
Understanding how car loans work, the different types, and what they mean for your pocketbook will land you in the driver’s seat of a car that suits your lifestyle and needs.
How Do Car Loans Work?
A car loan is a secured loan, meaning it uses collateral, in this case, your car, to guarantee payment. The vehicle will be repossessed if you miss a certain number of payments. If you try to get it back, it will cost 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 24-84 months. The interest and payment stay the same each month 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 five years (60 months) may fit well with your monthly budget, but that will cost a lot of extra money over time. Also, you don’t want the loan to outlive the car. Bite the bullet and go for the shortest loan term you can afford.
In 2023, the average new car loan was a record $41,665, with a $700 average monthly payment, according to Lending Tree. The average used car loan was $28,506, with a $525 monthly payment.
Car loan interest rates fluctuate but generally hover around 3.8% 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 2-3 times that, and it can rise to as much as 19.8% interest if your score is 500 or lower.
Car dealers offer 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 terrible and you have to get a loan with high interest, you can refinance it somewhere down the line. This is especially worth considering if your income or credit score improves.
So, shop 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 determine how good a deal you get, no matter who you go with.
Car Loan Comparison
When you shop for a car, the total payment is the number to pay the closest attention to. That goes way beyond the sticker price. It’s the loan amount plus the taxes, title, fees, and interest — that tells you how much you’ll pay a month. Remember that 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 consider taking out a six-year loan to “buy more car,” but see 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 you have a monthly payment more than $100 a month higher, and 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.
New vs. Used Car
Experts say it’s best to buy a car at least a year old and let someone else take the 20% depreciation hit that comes as soon as you pull a new car off the lot.
Buying a car that is only a few years old can help your bottom line, but new vehicles offer state-of-the-art tech and reliability that’s hard to pass up. Below we will break down the new vs. used car buying process and give readers an idea of what to expect when car shopping.
Should I Buy a New Car?
On average, drivers pay $700 a month to drive a new car and $525 a month for used vehicles, according to the Experian State of the Automotive Finance Market Report 2022.
A new car means you’ll spend less at the repair shop and won’t have to worry about a vague or insufficient vehicle history. While the sticker price will be higher than a used car, the interest rates will be lower, allowing drivers with good credit to save money on monthly payments. However, drivers should beware of rapid vehicle depreciation and higher insurance costs.
Pros of Buying a New Car
- Safety Features: Buying new means you’ll be driving with the assurance that your car is equipped with the latest vehicle safety technology.
- Better Financing: Financing a new car opens the door to agreeable lenders willing to offer better rates than they would for a used car. Low, even no-interest deals are achievable for drivers with good credit.
- More Purchase Options: New cars allow for many design and feature combinations. Mix and match paint colors, interiors, sound systems, and technologies like wireless Bluetooth, GPS, and rearview cameras.
- Less Maintenance: New cars won’t be in-and-out of the shop every month, and drivers can breathe easy knowing the detailed vehicle history –no previous owner means no costly surprises under the hood or beneath the dash.
Cons of Buying a New Car
- Higher price tag: New cars are more expensive. This fact and the next bullet are two crucial reasons drivers skip out on buying new.
- Rapid Vehicle Depreciation: New cars, on average, depreciate around 20% after the first year. That means the new $30,000 sedan you purchased in January 2022 will be worth around $24,000 a year later. It will continue to depreciate by around 15% yearly for the next four years.
- Expensive Insurance: New cars have a higher replacement value. This is the cost you pay to replace your vehicle after a total loss. A higher replacement value means insurance companies will charge more to cover your vehicle.
Should I Buy a Used Car?
A used car is cheaper upfront. The answer to buying a used car depends on what you’re looking for in a vehicle and what you can afford. However, expect to pay more in maintenance down the line.
Pros of Buying Used Car
- Cost less: This means paying less upfront and in registration and insurance. If you’re financing, your monthly payment will be much easier to manage.
- Slower depreciation: Vehicle depreciation isn’t a huge concern when buying used. Much of the devaluation will happen in the hands of the initial owner. This may leave room to spend more on other features you couldn’t afford brand new, like GPS or leather seating.
- Warranty: Many used cars still offer factory warranties. For instance, lease drivers often return the vehicle within three years, leaving an additional two years on the car’s five-year factory warranty.
Cons of Buying a Used Car
- Less financing options: Lenders don’t always offer loans for used cars, and if they do, the loan may be restricted by mileage and age of the car. In addition, finding a used car loan with decent terms will be tough to come by, especially if you have bad credit. You might have some luck at a credit union. If not, you may be stuck with in-house financing, which typically comes with very unfavorable terms.
- Used Warranty: Some drivers may wish to purchase an extended warranty since used cars may only have a year or two remaining on the original agreement.
- More maintenance: Used cars will carry more mileage and need more looking after than a new car.
- Vehicle history: Some cars will have blank spots in their vehicle history. The number of repairs a used car will need is only sometimes apparent, and there could be surprises in store under the hood, costly ones. Search for used vehicles with in-depth maintenance histories. Also, consider bringing the car into the shop for a brake or engine test.
Certified Pre-Owned Vehicles
A certified pre-owned (CPO) vehicle can be an excellent middle ground for drivers who want the reliability of a new car with the cost efficiency of buying a used one. These cars are part of a dealer’s or manufacturer’s CPO program that ensures a reliable party has thoroughly inspected them. CPO vehicles are slightly more expensive than used cars but will come with better financing options and may include features such as roadside assistance, repair costs, and more.
How to Choose Between Buying a New and Used Car
There are several factors to consider when deciding between a new or used car. Younger or first-time drivers will often opt for a used car since they are cheaper. This is a solid option for anyone that needs to buy on a strict budget. A used or CPO vehicle is a good choice if you’re looking for something that gets you from A to B safely.
Most, if not all, drivers would drive a new car over a used one, if the cost wasn’t a factor. New cars are more dependable, offer a broader selection of models and interiors, and offer comprehensive warranty packages that will keep your vehicle on the road for years to come. There is a mix of relief and pride in knowing that you’re the first driver behind the wheel of a vibrant new vehicle.
The downside to buying new is the cost, which is the main reason most drivers consider buying a used car. A used car will cost you more upfront and in insurance. The monthly payments can be steep, though new car drivers will be pleased when checking interest rates; the overall cost of purchase and inevitable maintenance is a lot for the average consumer to manage. And then there’s the rapid depreciation the car will undergo moments after departing the lot.
Ultimately the decision between new or used vehicles will come down to your lifestyle, budget, and long-term financial goals.
Budget for a Monthly Payment
Before you visit dealers, calculate your monthly budget and figure out how much 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 an excellent place to start on what to pay for a car. It means a 20% down payment, a four-year loan term, and vehicle expenses like the monthly payment, car insurance, gas, and maintenance at most 10% of your gross income.
Remember to budget car insurance payments. All but two states (Virginia and New Hampshire) require a certain level of insurance 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, remember that 27 states charge vehicle excise tax, paid yearly, based on the car’s value. Fortunately, help with car insurance payments is available.
» Learn More: Can I Make a Car Payment with a Credit Card?
Maintenance Costs
On average, a vehicle will cost $1,400 to maintain up to 2,500 miles. After this mark, costs will continue to rise until your car reaches 100,000 miles.
Drivers should consider the price of repairing an older used vehicle that will likely come with some dints, scratches, and mileage. Many used cars offer a partial warranty to help bridge the repair cost gap. It’s also wise to look into an extended warranty if your dealership offers it.
Features
The features you opt for will significantly impact the car’s sticker price. Prioritize a list of features that you value the most. If you’re adhering to a budget, you may need to make sacrifices regarding the interior, rearview camera, etc. However, if you spend a considerable time traversing long or remote distances, roadside assistance may be worth the extra money.
Get a Copy of Your Credit Score and Report
Before 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 same one a lender uses, but it will be close.
Each credit bureau (TransUnion, Experian, and Equifax) must 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 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.
Shop for Financing
You have two car financing options: 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 looking to take advantage of people 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 significantly help you negotiate terms with dealers. It lets them know that you’re aware you can get funding from someone other than them.
Direct Lending
A direct auto loan is a loan you apply for directly with a financial institution like a bank, credit union, or online lender. This is similar to how you would go about applying for a personal loan. The benefits include more control over the terms of your loan and flexibility regarding lenders. You can apply with as many or as few lenders as you please, whereas financing through a dealership may result in several credit checks beyond your control.
Should I 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 Kelley Blue book.
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 major automakers, like Ford, GM, Toyota, and Honda, have a financing arm. These are called captive finance companies, which account for 44.2% 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 shopping.
Dealer-Arranged Financing
These dealerships have relationships with banks that allow them to provide financing but don’t issue loans themselves. Instead, they function as a go-between with customers and banks. Dealerships take a loan from the bank and tack on a few percentage 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 usually 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 consistently accounted for one of the most significant shares of auto loans, competing with captive lenders for the top spot and making up 25.7% of the new car market. Historically, they were the biggest lender, but since the Great Recession, banks have been more reluctant to issue car loans. It is 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 22% 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 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 credit union member 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 several 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 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 appeal to a homeowner is 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 a good 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 a 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 your car loan.
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
Lenders are at considerable risk of making car loans to people with bad credit or no credit, so they take as many steps as possible to minimize that risk. They often 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. Drivers buying a car after bankruptcy will face even more challenges.
A borrower with bad credit does have financing choices, though. 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.
Save up for a sizeable 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 vehicle.
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 vehicle should be similar to 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 still needs to be determined, 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 signed is the one 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 to pay outright, if it means 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 your financial needs. Remember that dealers usually require you to finance through them to get the deal. Consider a nonprofit credit counselor if you want to improve your financial situation by managing your credit. Many nonprofit debt counseling and debt management companies are available to help you evaluate your debt load, and they may suggest a debt management plan to pay down your debt.
Be sure the nonprofit credit counseling agency you choose has a good track record with consumers. It should present 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 manage your debt to refinance down the line.
Sources:
- N.A. (2022) State of the Automotive Finance Market Report. Retrieved from https://www.experian.com/automotive/auto-credit-webinar-form
- N.A. (ND) 8 Advantages of Buying a Used Car. Retrieved from https://www.koonsmazda.com/buying-used-car.html
- Joy, D. (2023, Nov 15) Best Ways to Buy a Used Car with Bad Credit. Retrieved from https://www.whichcar.org/finance/buying/best-ways-to-buy-a-used-car-with-bad-credit/
- Martin, M. (ND) How Much Does Car Maintenance Cost Increase with Mileage? Retrieved from https://www.yourmechanic.com/article/how-much-do-maintenance-costs-increase-by-mileage-by-maddy-martin
- Duffet, M. (2022, June 23) The Difference Between a Direct Auto Loan and Indirect Financing. Retrieved from https://www.onemainfinancial.com/resources/loan-basics/the-difference-between-a-direct-auto-loan-and-indirect-auto-financing