At a glance:
How auto loan interest rates are determined
Summary of financing a car purchase
For most consumers, picking out the make and model car they want to buy is the easy part. Financing the car’s the hard part.
Your options include borrowing from the dealership, a financial institution, your home equity line of credit, or a relative or friend.
When taking out a loan, the terms will depend on several factors, including your credit score, the length of the loan, and whether the car is new or used. You should also consider any financing options in light of special discounts and incentives.
It's important to compare the cost of various financing options before settling on one, so you're aware of all the options.
Ways to finance buying a car
You have many sources at your disposal.
Options for financing a vehicle purchase are numerous and include banks, savings and loans, finance companies, credit unions, online financial institutions, home equity lines of credit, and relatives and friends. Many car buyers finance their purchases through their car dealer, who has access to loans offered by a number of finance companies, banks, and savings and loans.
Generally, when you buy a car, the salesperson will ask you if you plan to finance your purchase, how much you plan to provide as a down payment, and what type of monthly payment you can afford. Your salesperson will likely involve the sales manager and the finance manager in the negotiations over the car, as the financing package is a part of that negotiations process.
The major benefit of going through the dealer is convenience, as you can buy a car and finance it in one stop. The major disadvantage is that the terms of the loan may not be as favorable as you can get elsewhere.
The brick-and-mortar approach
Borrowing from a brick-and-mortar or online financial institution is another option. Before you fill out a loan application, check and compare rates for loans with varying lengths. Once you find the financial institution with the best terms for the type of loan you want, you can apply for the loan either before or after you've found the car you want to buy.
By applying before you find a car, you can get pre-approved for a loan, leaving you in a strong position when negotiating a price on the car you want to buy at a car dealership. This is one advantage of getting financing in advance, as you won't get the issues of the price of the car and the financing mixed up and can focus on negotiating a good price for the car.
Actually applying for the loan works similarly for both brick-and-mortar and online financial institutions: you fill out an application, either in person (for a local bank) or online (for a local or online financial institution).
The application will ask you a number of questions, including your income, your savings, how much you want to borrow, and what other loans you have, and will also ask you to give permission for the financial institution to check your credit history and credit score. Many financial institutions can get you approval within several hours of filling out the application.
Tap the equity in your home
If you are thinking of tapping your home equity line of credit to pay for a car purchase, check that you have enough funds remaining in your line of credit to cover the purchase. Also, make sure that the interest rate on your home equity loan is competitive with current car loan rates available from financial institutions or your car dealer.
If the rates are similar and you are comfortable borrowing on your home, tapping your home equity line of credit may be economical. Typically, you access money from your home equity line of credit by writing a check for the account provided by the financial institution that granted you the line of credit.
Keeping it in the family
Borrowing from a friend or family is another option. If you are short of money, don't have good credit, and have a good relationship with family members or friends, this may be a workable option. If you can work out such an arrangement with a family member or friend, it is best to keep the repayment on a businesslike basis by crafting an agreement that covers the amount borrowed, the interest rate on the loan, and the repayment provisions.
How auto loan interest rates are determined
A number of factors determine the rate you'll be offered on a car loan, including your credit score, the length of the loan, the condition and age of the car, and where you live. The largest factor of those is your credit score. Your credit score is a numerical representation of your credit history.
If you've handled credit well in the past by paying your bills on time, especially installment loans and credit card bills, your credit score will be higher. If your credit history is damaged or spotty, meaning that you haven't paid your bills on time and/or don't have much credit history, your credit score will be lower.
Generally, borrowers with credit scores of 650 and above get the most favorable rates, while those with scores of 550 and below get the worst rates. Before buying a car, obtain a copy of your credit score from a credit bureau or credit scoring company such as Fair Isaac, creator of the FICO score, at www.myfico.com.
The length of the loan also matters
The length of the loan is another factor in determining the interest rates. Loans with shorter terms — 24 or 36 months — get the best rates, while longer-term loans of 48, 60, or 72 months receive less-favorable terms. This is because the value of a car depreciates fairly rapidly, and the longer the loan, the less the car is worth. With lengthy loans of 60 or 72 months, there is a good chance that during the last one or two years of the loan, you will owe more on the car than it is worth. The newer the car, the better the rate.
Interest rates for new car loans are always lower than for used car loans. Again, this is because a new car holds its value better than a used car, which is more likely to experience mechanical problems than a new car. In some cases, your geographical location can also affect the interest rate you receive.
What to consider before buying a car
In an effort to move cars off the lot, many car manufacturers offer special discounts and incentives, mostly on new cars. Incentives vary, but usually include cash back in any amount from $1,000 to $5,000, an amount that you can use as is or add to your down payment. Special discounts can include premium packages of options offered at a discount and special financing offers.
Do you qualify for 0% financing?
A popular financing special deal is 0% financing. While this offer may lure buyers into a car showroom, it is generally only available to borrowers with excellent credit. If your credit score is less than 700, or in some cases less than 750, you won't get that rate.
If you do qualify, zero percent financing means that your entire monthly payment will go toward paying the principal on your loan and that you won't incur any interest charges throughout the life of the loan.
Do your research before you shop
When negotiating your purchase, it is advisable to do some research about the make and model of car you want to buy before visiting the dealership. By doing research on the Internet and consulting consumer sites with information on car prices, you can know how the manufacturer has priced the car and what types of dealer markups have been added, so you can negotiate those down as low as possible. Generally, the dealer markup is called ADP (additional dealer profit) or ADM (additional dealer markup) on the price sticker on the side of the car.
The Internet is useful for loan rate and length comparisons. Many consumer finance Websites offer loan rates from numerous sources and allow you to search by your location so you can compare what types of loans are available in your area to those available from online sources.
Summary of financing a car purchase
The automobile market is favorable to buyers in many ways. As an educated vehicle buyer, you should know the important sources of financing for your vehicle. You will also benefit from knowing how to gain the advantage in bargaining for the best loan terms.
Doing plenty of research beforehand — even before you're thinking of buying a car or truck — will come in handy and can save you a lot of time and money.
This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.
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