What You Need to Know About Auto Loans

More than 100 million Americans have auto loans with financing on the rise. New cars cost over $30,000 on average, which necessitates financing for most people. Even used cars can be costly at more than $18,000 on average. Auto loans typically have a term of 3 to 5 years with competitive interest rates compared to other types of loans. This can make it easier to afford the purchase of a vehicle, especially with a down payment that can reduce the risk of becoming underwater on a car loan.

There are many places to get auto loans today. Many consumers believe the dealership is their only option, but dealers usually offer the worst deals for buyers because most buyers arrive unprepared for financing. National banks are the largest providers of auto loans and may offer the best deals for well-qualified buyers, but there are other options. “Captive” finance companies that belong to automakers like Ford and Honda usually offer the best deals because the automakers subsidize the loans. It’s also important to check with other lenders like local banks, credit unions, online lenders, and peer-to-peer networks.

Before shopping for an auto loan, make sure you’re armed with knowledge to come out ahead with the best deal. Think of your car loan as completely separate from the car itself to properly compare your options.

1. Compare

Not all loans are created equal. Even two loans with identical monthly payments may have vastly different terms that affect the long-term affordability of the loan. Focusing solely on the monthly payment can lead to a bad deal. To get the top loan for your needs, there are a variety of factors to consider:

  • APR. There’s a difference between the interest rate and APR on your loan. An annual percentage rate is a broader measure that includes other costs to borrow the money such as fees.
  • Term. The longer the term, the higher the cost of your loan, even though your monthly payments will be lower. A 3-year loan will cost less overall than a 5-year auto loan.
  • Prepayment penalties. Some car loans come with a major drawback: a prepayment penalty that is charged if you make extra payments or pay off your whole loan early. These prepayment penalties are designed to ensure the lender gets their full profit and it can prevent you from saving on interest charges or finding a better deal later.
  • Fixed or variable interest. A fixed rate will stay the same for the length of the loan for predictable monthly expenses while a variable interest rate can change and result in higher payments later.

There are many sources for auto loans, so compare loan quotes from banks, credit unions, online lenders, and dealerships. If you have excellent credit, a bank is likely to give the best rate whereas dealerships typically offer the top deals for borrowers with flawed credit who can’t get approved elsewhere. Dealers usually don’t offer the best deals, so it’s important to understand your options before you step foot on the lot. This will also give you bargaining power when it’s time to negotiate.

2. Rates

Auto loans use amortization, just like mortgages. At the beginning of your loan, most of your payments will go toward the interest on your loan rather than your principal. As you pay down the loan, more of your payment will begin going toward principal to accelerate the payoff. Making additional principal payments during the start of the loan can help you reduce interest charges and pay off the loan faster.

Depending on your credit, you may qualify for a car loan with a single-digit interest rate that is lower than almost any other type of consumer loan. If you have bad credit, a subprime car loan may have an interest rate as high as a credit card, or up to almost 30%. To get a better deal on interest, take steps to improve your credit before applying and make a down payment that you can afford.

3. Pre-Qualify

No one wants to walk onto a car lot and find the car they want only to get denied for a loan. The pre-qualify process through a lender lets you know if you seem to be a good candidate for an auto loan based on the information you provide, including details about your credit score, assets, income, and debt.

Pre-qualification is different than preapproval, which is more concrete. A preapproval considers the same information as pre-qualification, but it carries more weight and may be used for additional bargaining power when purchasing a car. Pre-qualification and preapproval do not guarantee auto loans, but they should be the first step before shopping for a car.

4. Scams

Unfortunately, consumers with poor credit are often the target of car loan scams, especially scams that advertise auto loan modification or refinancing. If you ever have difficulty making your payments, it’s important to contact your lender first. Companies that advertise modification often take a fee for their “service,” tell customers to stop making car payments while claiming to negotiate with the car loan provider, yet deliver nothing but worsening of the problem.

Dealerships do not always prey upon consumers in a way that can be called a scam, but dealership financing can be a rip-off. Because dealers are middlemen when it comes to financing, they can pad financing “deals” with extra fees as profit. Dealership scams can also involve spot delivery — or allowing you to take your car home only to tell you the financing fell through to pressure you into signing a new loan with a higher interest rate — or even lying to you about your credit score for less competitive pricing.

5. Getting the Best Rates

Getting the best rates on an auto loan doesn’t happen by accident. To get the best deal, start by checking your credit reports. Correct any problems you spot to increase your credit score as much as possible. This may involve paying down credit cards, disputing incorrect information, or even requesting a credit limit increase with your existing creditors at least 2 months before applying for a loan.

From there, shop around for the best rates. Don’t assume the first lender you check will offer the best deal. It’s a good idea to request quotes from several types of lenders and take these quotes with you to the dealership for a final dealer offer.

Choose the shortest loan you can afford to decrease your costs over the life of the loan and remember that the total cost of your loan is most important, not the monthly payment.

6. Used Car Loans

Used car loans are a bit different than loans for new cars. New car loans tend to have much lower rates than used cars, although financing periods are also much longer. New car loans may also come with money off the car’s sticker price or special rates like a 0% APR on certain models.

Still, there are advantages to used car loans. Used cars usually offer a lower average price that already takes into account depreciation, or the loss of value as a car ages. New cars lose value as soon as they are driven off the lot with the most value lost during the first year. With a used loan, there is a shorter loan term to pay off the debt faster. These loans also offer slower depreciation. While a new car loses an average of 20% of its value during the first year, purchasing a used car means someone else has already taken this hit.

7. Credit Score

Your credit score determines whether or not you will qualify for an auto loan and the terms you can receive. The better your credit, the easier it will be to qualify for the best possible interest rate. This will reduce your borrowing costs over the life of your loan.

Before applying for auto loans, check your credit reports from TransUnion, Experian, and Equifax. If you spot incorrect information or accounts that do not belong to you, dispute the errors with the credit bureau. Ideally, you should begin cleaning up your credit reports 2-6 months before you intend to buy a car.