Auto Loan Guide
Whether you are in the market for your first car, you want to upgrade from your old vehicle, or you’ve decided to purchase a second car, chances are you don’t have enough cash laying around to purchase a new vehicle without some assistance.
Auto loans are loans which allow individuals to borrow money for the specific purpose of purchasing a vehicle. With an auto loan, you will be paying for the full amount of the car that you choose plus interest.
While this seems straightforward, there is a lot that you should know before taking out an auto loan. Different types of auto loans, new vs. used cars, buying vs. leasing, and how to find the best auto loan for your situation are elements with which you should be familiar.
Types of Auto Loans
- Secured Auto Loans
Secured auto loans are loans which require you to hand over an asset as security against your loan. In most cases, your lender will place a lien on the car that you are purchasing. However, in other cases, your lender may choose to put a lien on your home or another car that you own.
Placing a lien on one of your valuable assets allows the lender to protect itself in case you default on your loan. If you are unable to pay back your loan, your lender will sell your property to pay off the rest of what you owe.
It is much easier to get approved for a secured loan. They also are generally ideal for individuals with low credit scores. Typically, secured loans also have lower interest rates and come in larger amounts.
- Unsecured Auto Loans
As the name would indicate, unsecured auto loans do not require you to put up any property as collateral. If you end up not being able to pay back your unsecured loan, your lender will likely attempt to get their money back through other means. This could include taking you to court or sending your debt to a collection agency.
Unsecured auto loans tend to come with higher interest rates as they are much riskier for the lender. However, if you have a good credit score and want more freedom in choosing your vehicle then an unsecured loan may be a good, comparable option for you.
Precomputed Interest & Simple Interest Auto Loans
You should also understand how your lender will calculate the interest on your loan before taking one out.
Precomputed interest auto loans create a strict payment schedule in which every payment has a predetermined amount of interest. This means that early payments will not affect the total amount that you are required to pay. As a result, precomputed interest loans might not make much sense financially if you plan on paying off your loan early.
On the other hand, simple interest loans determine interest on a periodic basis. This means that the interest on your loan is regularly recalculated based on the amount of principal that is still owed. This makes simple interest loans more sensible if you are able to make early payments. Early payments reduce the amount of principal that is owed, which reduces the amount that you will have to pay in interest over the life of the loan.
New vs. Used
- Why Buy New?
- Infrequent Maintenance: While buying a used car may save you money upfront, you might end up spending more on maintenance in the long run. New vehicles will likely not require any maintenance for the first few thousand miles. After which, they will likely only need the occasional oil change.
- Mileage: Unless you plan on going electric, gas will be your one of your largest long-term expenses. Every year, car manufacturers continue to improve the fuel efficiency of their vehicles. For this reason, purchasing a new car rather than a used one is ideal if you plan on sticking with your car for a long time.
- Warranty: One of the riskiest aspects of buying a used car is that it is much more likely to break down due to unanticipated flaws. In some cases, these issues may cause your vehicle to be broken beyond repair. Alternatively, a new car will come with a manufacturer warranty. This will protect your investment from errors made by the manufacturer or previous owner(s).
- Why Buy Used?
- Cheaper Upfront Costs: Sometimes, you simply cannot afford to purchase a brand new car. Despite the long-term cost benefits of newer vehicles, used cars are often the only affordable option. The cost depreciation of used vehicles drastically lowers their price.
- Reliable Used Car Dealerships: While you might be hesitant to purchase a used car due to the potential for severe unknown issues, used car dealerships, like CarMax, have taken steps to protect buyers from losing their investment. Purchasing a used car from one of these dealerships can help ensure that you are able to purchase a reliable vehicle at an affordable price.
- Certified Pre-Owned Programs: Many vehicle manufacturers, including luxury brands like Mercedes, have factory-certified pre-owned programs. These programs guarantee that your used car is in excellent condition. They often also offer extended warranties to protect your vehicle from unforeseen issues.
Buying vs. Leasing
- What is Leasing?
When you lease a car, you are paying for the depreciation of the car’s value plus interest for the duration of your lease. You will sign an agreement which dictates the length of your lease and your monthly payments. Once your lease is up, you take the car back to the dealership and pay any extra fees.
- Pros and Cons of Buying
- Buying your car will save you money in the long run.
- Your vehicle can be used as a trade-in whenever you decide to upgrade.
- You can sell the car whenever you’re ready.
- You can make any changes or modifications to your vehicle as you please.
- Buying a car will come with higher monthly payments.
- You will likely have to pay a larger down payment.
- Once your warranty expires, you are responsible for any and all maintenance expenses.
- Pros and Cons of Leasing
- You will have a very small, or sometimes zero, down payment.
- Your monthly payments will likely be much lower.
- You will be able to choose from higher-end vehicles.
- You will be responsible for less in sales tax.
Your mileage will be limited.
- Once your lease is up, you no longer own the vehicle.
- If you need to terminate your lease, you will be responsible for costly cancellation fees.
- Leasing over the long-term is more expensive than purchasing a vehicle.
How Much Can You Afford?
- Your Monthly Income
First thing’s first, you need to know how much you can pay every month based on your monthly income. Your lender will also need you to provide proof of income and employment. Keep in mind that a car is a depreciating asset, so you should not invest a significant portion of your income into one. Typically, 20% of your income is considered an acceptable amount to put towards car payments.
Your credit score will be one of the main factors when calculating the interest on your auto loan. While the average auto loan interest rate is somewhere around 7%, a credit score below 680 could cause this rate to drastically increase (and of course the inverse is also true). You should take into account what your interest rate might be based on your credit score before taking out a loan.
How much money will you be able to pay upfront for your vehicle? If the car that you choose costs $25,000 and you are only able to afford a $1,500 down payment, you will require a fairly large loan compared to someone purchasing the same vehicle with a $5,000 down payment. Determining the largest amount that you can afford as a down payment will help you calculate how much you need.
- Trading in Your Old Car
Trading in your current car can significantly reduce the amount that you owe on your new car. The trade in value of your old car plus any additional down payment can reduce the amount of your monthly payments and/or the length of the loan.
- Length of Loan
Lastly, you should determine how quickly you expect to be able to pay off your loan. If you are taking out a precomputed interest loan, it is important that you make the length of your loan as short as possible. This will help you save the most money long-term. However, for simple interest loans, it is less important as you can always pay it off early. Early payments on simple interest loans will reduce the total cost of the loan.
How to Get an Auto Loan
- Find Multiple Suitable Lenders
You should find multiple auto loan lenders that meet all of your needs. Some lenders will have stricter requirements for approval, but provide much better offers. Meanwhile, other lenders may have loans with less ideal terms but that are much easier to qualify for. You have a few options for lenders:
Traditional Bank. Large banks generally offer secure auto loans. They have multiple branches and competitive rates. Their service won’t be as good as a credit union.
Credit Union. Local credit unions offer competitive rates to large banks with better service. You’re more likely to talk to a person then a phone advisor.
Dealer or car-manufacturer. Car dealers will have relationships with the car manufacturer’s finance arm or other lenders. You can get a loan at the same time you buy your car.
Non-traditional online lenders. Online lenders offer a new way to shop for loans. You may find better rates or more flexibility. Just don’t expect to meet them in person.
You should be sure to take recommendations from friends and family when looking for a lender. You should also read reviews to confirm the legitimacy of the loan providers. Many lenders will offer loans with no credit checks or guarantee low interest rates. However, these lenders might take advantage of you by hiding extra fees behind these promotions.
- Submitting Your Application
Once you’ve narrowed your options down to a select few lenders, it’s time to submit your applications.
- Your loan application will need a lot of personal and financial information, including:
- Your bank account information
- Your social security number
- Proof of income
- Proof of employment
- Identifying documents (passport, driver’s license, birth certificate, etc.)
Additionally, lenders will perform a credit check. You should make sure to fill out your applications over a short period, typically 14 days. This will make it so that credit reporting agencies treat these credit checks as a single inquiry.
- Signing the Loan Agreement
After your application has been approved by your lender(s), you will receive formal offers. These will contain the interest rate, loan duration, additional fees, and disbursement information.
At this point, it’s up to you to review any and all offers and choose the one that best fits your needs.
Refinancing Your Auto Loan
- What is Refinancing?
You’ve likely heard of people refinancing their mortgage, but you might not know that refinancing your auto loan is also an option.
Refinancing simply means using a new loan to pay off an existing auto loan. When you refinance your auto loan, you will also be required to put up your vehicle as collateral. Refinancing allows you to negotiate new terms for your loan. This includes your interest rate, monthly payments, and the duration of your loan.
- Why Refinance Your Auto Loan?
Refinancing can be an appealing option for a variety of reasons.
One of the most common reasons for refinancing is extremely high interest rates. Whether you were unable to get a better offer at the time, or you just didn’t know any better, you might find that your interest rate is needlessly high. Refinancing can be a great option to lower your interest rate.
Additionally, you might find that you need more time to pay off your loan or that you are able to pay it off earlier than expected. In either case, refinancing can help you negotiate a loan term that better suits your needs.
- When is Refinancing a Bad Idea?
Refinancing your auto loan might seem very appealing due to the reasons listed above. But, there is one reason which makes refinancing a poor decision in many cases.
Cars are considered depreciating assets. They lose their value over time. In many cases, refinancing your auto loan might lead to lower monthly payments, but it will also lead to a longer loan term. The longer it takes you to pay off your auto loan, the more likely you are to go upside down on your loan. Your car will be worth much less once it is finally paid off. As a result, you may have trouble selling or trading it for a fair amount when it's time to upgrade.
Tips for Finding the Best Offer
It can be difficult to be sure that you are receiving the best auto loan offers available. Fortunately, there are a few things you can do to feel more confident that you are looking in the right places.
First and foremost, you should request quotes from multiple lenders. You don’t have to go with any of these lenders, but this should give you a good idea of what kind of offers you can expect.
Be aware that some lenders will provide extremely friendly offers in order to entice you. But, if an offer seems too good to be true when compared to other quotes, it likely is.
Getting pre-approved for loans will help you get more specific and accurate offers than just requesting quotes. Pre-approval requires you to submit fairly standard information, including identifying information and basic financial information. They will use this information to determine the best offer they can make you. Many lenders will also perform a credit check at this stage. You should make sure that it is a soft credit inquiry so that it doesn't affect your credit score.
Frequently Asked Questions
- Can I get an auto loan if I have bad credit?
Having a poor credit score will definitely make it more difficult to find an auto loan with favorable terms; however, rest assured, it can be done. Pre-qualifying for loans can be used to negotiate better terms with other lenders. Additionally, having a cosigner can help reduce interest rates. Check out this article for more information.
- What is APR?
APR, or annual percentage rate, is simply the number that represents your interest rate. You should be aware of how APR is calculated before applying for an auto loan.
- What does it mean to be upside down on a loan?
Being upside down on an auto loan means that you owe more money on your vehicle than it is worth. For example, your vehicle may have cost $20,000, but mileage and wear and tear have caused the value to drop to $10,000. Meanwhile, you might still have $12,000 left on your loan. This means that if you were to trade in your vehicle, you wouldn’t get enough money back to pay off your loan.
- When Will I Receive My Money?
The time it takes for your money to be disbursed to you is entirely dependent on your lender. You should discuss these details with your loan provider before signing your agreement. However, you can typically expect to receive your funds within a few days of signing your loan agreement.
Based on a secured $30,000 auto loan with 4.5% interest and 60 month life