Auto Loan Basics Spelled Out: Lending 101
Ever notice how there are things it feels safe to ask about and other things you feel like you’re supposed to just magically… know?
A friend of mine recently mentioned she’d purchased a car. She told me the color, make, and model. I asked about the engine, its features, and how it felt to drive. These are the polite things one does when someone is excited about a recent purchase, right?
What I really wanted to know, however – but didn’t feel I could ask – was how she financed it. What interest rates are auto lenders offering these days? Also, what sorts of terms can someone with average or even bad credit get? Is the process as painful as I seem to recall from when my parents were doing it a generation ago, or has it gotten any better?
Too many of us feel foolish asking about auto loan basics when there’s really no reason we should. You’re not missing some critical link in your genetic code. You weren’t skipping the day they covered auto financing in Adulting 101. Maybe you’ve simply not financed a vehicle lately. (If it makes you feel any better, I know plenty of people who have financed their cars. Those often still don’t quite know how it works.)
Let’s look at a few auto loan basics.
What Is a Car Loan and How Does It Work?
I know – it sounds so simple, right? But for most of us, purchasing a car is one of the biggest and most important financial decisions we’re going to make. Surely that’s worth a little planning ahead?
There are two basic types of auto loan: direct lending or dealership financing. With direct lending, you make arrangements with a financial institution of your choice. Usually before you buy. Your
local bank, credit union, or other auto lenders are usually happy to share their current rates and terms with you. This gives you the freedom to comparison shop ahead of time. You can figure out your budget and realistic payment options before even talking to a car dealer. Pre-approved financing can sometimes help you negotiate a better price. Especially since your funding is already secured.
Dealership financing is not dramatically different. However – as the name suggests – takes place through the dealership. Some automakers have their own financing departments. It means your loan is actually through them. Most have arrangements with outside finance companies. They transfer your loan to them before your first payment even comes due. Dealership financing offers you additional convenience in that you know exactly what car you want. You also know how much you need to finance before setting up the loan. Plus, it’s available whenever the dealership is open. Either late nights, long weekends, holidays, etc. Dealers also love running promotions with special interest rates or other terms which you might find appealing.
Did you know?
The average new car loan in 2018 was $30,977, while a used care loan was $19,861. Generally speaking, a higher the credit score results in a higher loan amount. Another interesting stat is those in the 2nd highest credit tier borrowed the most coming in on average at $32,630 for new cars and $21,293 for used ones.
The Car Loan Process
Don’t feel foolish if you’re not sure how to shop for a car loan. Auto loan shopping isn’t difficult, but it is different than it was a generation ago.
The good news is that technology has made it easier than ever to get started. The first thing to do is to figure out a realistic budget using an online auto loan calculator. In the 21st century, this is an essential requirement of Auto Loan Basics 101. Most versions will let you play with interest rates, lengths of the loan, and other factors to figure out what works best for you. Then, check your current credit report. The earlier you begin this part, the easier it will be to address or correct any errors.
It’s also a good idea to research your vehicle options ahead of time. This should be part of everyone’s auto loan basics, but sometimes our emotions take over and we get careless. Make note of what features you consider essential and which would simply be nice to have. Check the range of prices you might be able to negotiate using sites like the National Automobile Dealers Association, Kelley Blue Book, or Edmunds.
Once you’ve got your information together, you’ll find auto loan shopping online to be relatively painless. You’ll probably be surprised how quickly you hear back from multiple auto lenders. Obviously you should consider each offer carefully before committing, but personally, I much prefer having lenders compete for my business over the old way. Maybe our parents were willing to slog from lender to lender, sit in an endless array of hygienically-suspect chairs, and endure suspicious looks and questions from disgruntled loan officers, but you don’t have to.
Unless you’re just into that sort of thing, of course. In that case, have fun.
How Is Auto Loan Interest Calculated?
This is another part of auto loan basics which too often makes us feel foolish when there’s no reason we should. Most auto loans involve simple interest, meaning you pay interest only on the principle of the loan (the actual amount borrowed to pay for the vehicle and related costs like taxes). The alternative is compound interest, in which the borrower pays not only on the principle amount but on any remaining interest owed – interest on interest, as it were. Usually you only want to hear the term “compound interest” when you’re earning money on your savings!
If you want to dive into the nitty gritty details of what interest can look like over the life of your loan, check out this breakdown by IFS. They explain it quite effectively with plenty of visuals.
Who Offers the Best Auto Loan Interest Rates
How Do Car Payments Work?
This is an easy one, right? They send you a bill each month and you mail in your check. Done!
It’s true that once you have the car and have signed the paperwork, the terms are largely set and you should pay what you owe each month. That’s foundational to auto loan basics. But let’s look at those payments and what goes into them ahead of time. Maybe we can avoid a few careless mistakes.
You’ve probably figured out that a lower APR (“annual percentage rate”) means you’ll pay less over the life of the loan. That’s absolutely true, but APR is not the only factor. The length of the loan matters as well.
Make Your Payment…
According to Lending Tree, “Delinquency rates for auto loans trend together including loans 30 days past due, loans 90 days past due and loans at least 90 days past due. All three peaked following the 2008 downturn, with 30-day delinquencies spiking to near 11% in early 2009, but have stayed around 7% since 2011.”
Let’s take an example!
Let’s say the car you want will cost you $30,000. You’ve managed to save about $3,000 in anticipation of this glorious day, but that’s clearly not enough. You check around and discover one lender who’ll loan you the full amount and let you pay it back over 48 months, another who’ll offer you 60, and a third who starts at 72. That last offer has the lowest payments of any of them and you get to keep your $3,000! Sounds good, right? And if those are the terms you want, there’s nothing wrong with that.
Still, what are you paying in total over 72 months for the same car you could finance for 60, or 48? That should always be something you consider (not just the size of your monthly payments). You’d be surprised at the difference, even if the interest rate is the same for each – and it’s probably not.
The third factor is your ability to make a down payment. Remember that $3,000 you set aside? Applying that upfront would not only make your monthly payments be lower, but the total interest you’ll pay over the life of the loan would be less as well. It might even be enough to help you do 60 months instead of 72, or 48 instead of 60, which then saves you even more.
Don’t let the complex interplay of factors intimidate you. You don’t have to take Algebra II at your local community college before you buy. Just remember those handy online loan calculators we mentioned from Auto Loan Basics 101. Run a few of the options and see what happens. It doesn’t cost you anything to play with it a bit and prepare; it might cost you in the long run if you don’t.
Auto Loan Rates
If you’re wondering what sort of interest rates you’re likely to secure for your auto loan, the solution is pretty straightforward – try several lenders and see. Interest rates vary widely over time and from lender to lender. Add to the mix the various promotional rates offered by dealers anxious to move some stock off the lot and it’s impossible to say ahead of time what a “typical” rate might be.
With that in mind, here are a few auto loan basics which determine that rate, whatever it might be:
Your credit history.
I realize this is a bummer for some of us, and believe me – I totally understand. But we might as well acknowledge up front that this is a pretty big factor in determining what we’ll be paying for our loan. On the other hand, a reasonable auto loan is a great way to rebuild or strengthen that same credit history by making sure you’re realistic about what you can afford and making your full payment on time every month.
The length of the loan.
Generally speaking, longer loans come at higher rates. Even if the rate is the same, you’ll pay more interest over time with longer loan terms. If you gotta do 72 months, do 72 months, but if you can do 60, or 48, consider those instead – even if it means dialing back on a feature or two in order to make it happen. Keep in mind that down payments may or may not reduce your interest rate, but they will reduce how much interest you’ll pay over the life of the loan.
What you’re buying.
New cars are more likely to have introductory rates or special financing. Used cars are considered a greater risk for lenders, since their resale value is already lower and the chances are good you’ll owe more than the car is technically worth at some point down the road. Pre-owned vehicles tend to cost less – which is great – but come with higher interest rates.
Do some auto loan shopping ahead of time by comparing your online options to your favorite banks or credit unions. Scan local ads for dealer promotions and be ready to ask about special financing, then compare it to what you’ve already researched from other lenders. There’s no absolute right or wrong, best or worst on this one – it all depends on who’s offering what, when, and under which conditions.
I realize it’s not as exciting to do loan calculations and compare rates from various auto lenders and look up “blue book” values and all that when we’re buying. There’s a certain thrill to following the spotlights and the inflatable dinosaurs and test driving a few dream cars in candy apple red or adding booming stereo packages before signing on the dotted line in triplicate and cruising home covered in new car smell. It can feel good to leap before we look and figure we’ll worry about the details later.
But those car payments keep coming due every month whether we put in real time and consideration up front or not, and by about month three they’re not particularly thrilling no matter how sexy the paint job or how loud those woofers. Maybe it’s worth sacrificing a little “living on the edge” on this one in order to prioritize auto loan basics? It will reduce your stress and improve your financial security for the remaining years of the loan, which is very much a win – however unexciting it might seem compared to those inflatables.
Do Car Dealerships Prefer Cash or Financing?
Generally, dealers prefer financing, since in addition to whatever profit they make on the actual vehicle, they can count on a little extra from finance charges and the interest you’ll pay. Even if they sell your loan to an outside lender, they net a little extra when you finance through them.
That doesn’t mean you have to finance if you want a good deal on a car. If you do walk in pre-approved from an online lender or local financial institution, or with your checkbook ready to simply pay the full amount, however, you might avoid committing on how you plan on paying until after you’ve come to an agreement on the final price.
They’ll ask, of course, just like they want to know if you plan on trading anything in before they start talking specifics with you. That’s auto loan basics from the dealer’s standpoint. That doesn’t mean you have to do everything their way, however. There’s no need to be dishonest or coy, but these days, dealers realize there’s more information out there than they can control about car values and reasonable pricing. They know you have options. Don’t be afraid to proceed based on what you want to know and how you want to handle things. They’ll either work with you on those terms or they won’t, and you can try somewhere else.
“Be willing to walk away” is normally reserved for Auto Loan Basics 201. You’re ahead of the curve already!
How Does Your Credit Score Effect an Auto Loan?
Let’s start with the obvious: a better credit score will usually get you a better interest rate on your auto loan. Anyone who tries to convince you otherwise is either dishonest or delusional. Now that that’s out of the way, let’s talk about a few less-obvious factors when it comes to your credit score and getting a decent auto loan.
First, check your credit report before you get serious about car shopping. It’s a pain to fix errors, but they do happen and it can be done. Pay particular attention to anything your credit report suggests about past vehicle financing.
That brings up a second point. Lenders considering you for an auto loan are primarily concerned with your track record when it comes to auto loans. I realize that sounds a bit silly. However it’s worth considering. Let’s say you’ve done pretty well paying off two previous vehicles – or maybe one used car and one other big-ticket item like a furniture purchase. On the other hand, your credit score is unimpressive due to outstanding medical bills or other uncontrollable expenses. We agree that your overall credit score still matters. Dealerships and online lenders will notice when the issue doesn’t seem to be your ability to pay for planned purchases. Keep in mind they want your business; all they’re worried about is whether or not you’re going to pay them in a timely manner.
Finally, you’ll never get a loan for which you don’t apply. The abundance of local banks, credit unions, and online lenders means financial organizations have to take a few risks if they’re going to do enough business to compete with your other options. The world of credit isn’t what it was a generation ago. Get your information together, then ask.
How To Get A Car Loan With Bad Credit
At the risk of sounding like a broken record (ask your mom what a “record” is if you’re not sure), the most important step towards getting the loan you want, even with your credit, is to apply for the loan you want, even with your credit. Seriously, what’s the worst that could happen? A few lenders might say no, or propose slightly different terms than you’d hoped?
Now that you’re sick of me repeating that point, let’s talk about a few of the many things you can do to increase your odds when it comes to getting the best possible loan (even with your credit):
Get a co-signer.
This should be someone with a strong credit history who trusts you enough to put their credit rating on the line to help you out. If you make your payments as scheduled, your credit record improves without any change to theirs. If you don’t, their credit record is damaged and they may eventually be expected to pay what you’ve promised – so let’s take this one seriously, shall we?
Make a down payment.
It’s not a surprise that you’re going to need a car someday. Saving money is never the easiest thing in the world, but even a few thousand dollars up front can change the equation in terms of monthly payments, interest rates, and even the willingness of lenders to take a chance on you.
Look over your credit report.
Address any errors or fix any oversights on your part if possible. (You notice we keep returning to this theme? It’s like it’s important or something and yet many people simply don’t do it ahead of time. Hmph!)
Research financing options before you shop for your vehicle
Know what sort of APR (annual percentage rate) is being offered through various lenders and the typical prices negotiated for several of your top choices. Play with some online loan calculators so you understand the way various factors shape potential loan payments. Compare local banks, credit unions, and online lenders, even if it means delaying your car-shopping for few days while you do. Don’t be demanding or obnoxious, but there’s nothing like knowing what you’re talking about when you’re trying to secure financing.
Research vehicles, typical selling prices in your area, and other logistics before walking onto that lot.
Know what features are essential to you and what you can live without, and be ready to compromise a bit if the dealer has something pretty close in stock that they’re ready to move. And for goodness sake, don’t get fixated ahead of time; have several options so you can honestly walk away if you’re not happy with the terms. Know your non-negotiables and on what points you can be flexible going in – that’s Auto Loan Basics: The Prequel, my friend!
Don’t become fixated on monthly payments.
Look at overall loan terms. We talked about this above, remember? I’m only mentioning it again because the whole process can sometimes leave us feeling a bit glazed over and I figure a little reminder wouldn’t hurt. You’d do the same for me, wouldn’t you?
Bring a trusted friend or family member.
Sometimes we think more clearly if we bounce things off that colleague from work who always asks the right questions or that sister who isn’t afraid to be irritating when she knows we’re about to do something we’ll regret. Anyone familiar with auto loan basics and willing to be a second set of eyes and ears in the process. (Your spouse or significant other doesn’t count. They’re probably not really a “neutral outsider” when it comes to major purchases – at least I hope not. If they are, you’re doing relationships wrong, my friend.)
Where To Shop To Get A Car Loan
I assume at this point you’re tired of me telling you to check with your local bank and credit union. Besides, you probably know how to shop for a car loan this way – walk in, sign the list, and talk to whoever calls your name, right?
If you thought to yourself,
“But first I should check my credit report, estimate what I can reasonably afford, narrow down my vehicle options, and experiment with an online loan calculator…” then YOU GET A STICKER and ONE THOUSAND BONUS POINTS! You are officially gifted and talented when it comes to auto loan basics.
What you may be less certain about is finding reputable online auto lenders. The internet is a magical place, but you’d be foolish to stake all your hopes and dreams at the first search engine result that comes up (which was probably a paid advertisement anyway). That’s where we come in.
We use our expertise to connect buyers with online auto lenders. This flips the traditional dynamic associated with getting an auto loan or any other kind of financing. There’s no reason you should be overwhelmed or frustrated, going from desk to desk like Oliver Twist wanting more warm mush. What you are is a client, empowered to choose from numerous marketplace lenders who compete for your business by putting together their best solutions and hoping you’ll consider giving them your business.
These are experts in creative financial solutions who understand your situation. They exist to help people like us figure out how to figure out situations like this. Some even specialize in helping you rebuild your credit if things haven’t gone, you know… perfectly in years past.
You’re probably wondering about the catch. What are we selling you? Nothing – nothing at all. Loanry gathers some basic information and offers a few tools to help better determine your needs, then helps you find a participating lender to secure a solution both of you decide is best. We don’t charge you any fees or take any payments from you. Period. Once you’ve found a lender that meets your needs, the rest is between you and them.
Good luck, happy driving, and be safe. You’re now an expert in auto loan basics and ready to share your wisdom with others.
After you get that car, of course.
Blaine Koehn is a former small business manager, long-time educator, and seasoned consultant. He’s worked in both the public and private sectors while riding the ups-and-downs of self-employment and independent contracting for nearly two decades. His self-published resources have been utilized by thousands of educators as he’s shared his experiences and ideas in workshops across the Midwest. Blaine writes about money management and decision-making for those new to the world of finance or anyone simply sorting through their fiscal options in complicated times.