Your car might be one of the most important assets that you own, not necessarily in terms of the value of the vehicle, but for the role it plays in your life. It gets you to work, the kids to school and gets you to the grocery store — your car is a major necessity.
What happens if the car breaks down and is too costly to repair? What if it’s past its prime and is overdue for a trade-in? You may need a loan to fund your purchase. Here’s everything you need to know about getting your car loan.
Step 1: Do an Assessment of Your Needs
Take a look at what you will use your car for and the cost of the type you want. If you only need it for yourself to drive to work, then perhaps a small vehicle might do. Ferrying kids to and from soccer games and hockey practice might require an SUV.
Consider your driving patterns. Will you drive mostly on gravel roads, or will most of your commuting be long-distance highway driving? If you soon expect changes in your lifestyle — kids, job changes, going away to college — factor them into your needs analysis.
The type of car you decide to buy should be able to address those needs.
Step 2: Consider Your Finances
Once you’ve narrowed down the type of vehicle you need, you’ll have a better sense of whether you can afford it. The next step involves doing an assessment of your financial situation. This is where a budgeting app can help you. Most apps track your monthly income and spending and can tell you whether you can afford a car payment.
Ask yourself if your finances are already stressed, can you add monthly/quarterly installment payments toward a car loan?
Remember to include not just the car purchase price in your affordability test, but also other recurring costs such as:
- Regular maintenance
- Periodic repairs
- Auto insurance
- License and registration
- Title transfer costs
- Financing costs
A recent study by the American Automobile Association (AAA) revealed that the average annual cost of owning and operating a car is approximately $8,850 annually.
Step 3: Determine Your Creditworthiness
This step involves doing an assessment of your credit profile. Your credit score will help determine the terms of any external financing. This is where you need to get a copy of your credit report and review it for possible clues about your creditworthiness.
Typically, lenders will use your FICO or Vantage credit score to determine interest rates, for example. FICO scores range from poor (less than 350) to exceptional (800+) and usually entitle you to more favorable interest rates. Higher scores equal better creditworthiness.
If your credit score is lower than you would like it to be, it might be best to wait until you’ve significantly lowered your debt before re-assessing your creditworthiness. It might be worth it if it means you’ll qualify for a lower-interest car loan.
Step 4: Get Around Less-than-Stellar Credit
You don’t need an exceptional credit rating to qualify for a car loan. Your credit score could be a deciding factor in the amount of money the lender is prepared to loan you. The larger your down payment, the less you’ll need to borrow.
You can still qualify for a smaller loan even with a fair credit score.
If you don’t have enough money for a down payment, consider deferring your car purchase until you do save enough to make that initial deposit. The best way to save money is to prepare a budget and stick to it. Invest any savings wisely or redirect it toward your down payment.
Poor credit won’t necessarily shut you out of the auto loan market. Consider asking a friend or a relative with good credit history to step-in as a co-signer. Be considerate of your co-signer’s legal obligations. Lenders will hold him/her responsible if you default on the terms and conditions of the loan. This will impact your credit profile and your co-signer’s, too.
Step 5: Choose a Lender
It’s now time to make a decision on where you should get your car loan. You typically have three choices: direct lenders, dealer-arranged financing and dealer-direct financing.
Approach your bank, credit union or other financial institution directly to discuss a car loan. The advantage of working directly with your own financial institution is that it already has a relationship with you, which might entitle you to some preferential lending terms as an existing customer.
Getting a quote from your own bank/financial institution shouldn’t stop you from shopping around for car loans from other direct lenders. In fact, you should approach at least 2 or 3 other direct lenders and compare terms.
Depending on your credit profile, direct lenders may even offer to pre-approve you for a loan. Having a pre-approval letter in hand can be a vital tool during negotiations with your car dealer. You could potentially use that preapproval to gain additional pricing or financing concessions from the dealer.
Most auto dealerships offer to finance cars purchased from them. They can tap into their network of direct lenders and offer you quotes from several competing lenders.
The advantage of using dealer-arranged financing is that it provides a convenient one-window (buy here, pay here) option for you to buy your car and arrange for a car loan under one roof. Because car dealerships are “commercial borrowers,” direct lenders usually offer them more favorable terms than they do to their retail clients.
The disadvantage of using dealer-arranged financing is that the quotes provided might not include your preferred lender. Dealers may add a mark-up on the lending rate or charge you an extra fee for arranging the loan. However, if you have a pre-approval letter from your direct lender with better financing terms, you could use that to leverage a better deal from your dealer.
Some car dealerships are part of an extended chain of companies that also operate garages, body shops and car loan financing companies. If your dealership is part of such a network, it may entitle you to get your car loan directly from the dealer (rather than through a dealer-arranged lender).
Like dealer-arranged financing, this option could involve costs that are over and above the cost of interest, such as administration charges.
Because the dealer is primarily interested in selling you the vehicle, it may be able to tap into manufacturer-sponsored low-cost financing options for buyers. If your dealer offers this type of program, you could receive additional loan incentives that make it cheaper to use dealer-direct financing.
Step 6: Make Your Decision
By this time, you should have all the facts necessary to make an informed decision about which car loan is best for you, including:
- The type of vehicle you need
- The purchase price of the car
- The financing costs from various alternate lenders
- Ownership costs, including car insurance and parking (especially if you don’t have access to free parking at work or where you live)
- Your annual vehicle operating and maintenance costs
Analyze all the costs, especially the quotes from each lender, and reconcile them against your monthly budget. The length of your loan term, the annual percentage rate (APR) and the frequency and size of the installment amount will be key factors in making your decision.
For example, some lenders might offer a 7-year (84-month) repayment period with smaller installments, while others may quote you slightly larger installments over a 5-year (60-month) term. Instinctively, this may tempt you to opt for the lower installment longer-duration loan, but know that you’ll likely pay a higher interest rate.
Longer-duration loans typically come with higher interest rates. Even though you pay less during each payment cycle compared to the shorter-duration loan, you pay it for longer.
Other Points to Consider
If you own an existing vehicle, your car dealer might be able to offer you a trade-in for your new car. The trade-in-value should reduce the cost of the new car, which could ultimately reduce the amount of your car loan.
After you do your loan comparison and determine that the car you want/need does not pass your affordability test, choose something less costly. If buying a new car is beyond your financial resources, consider taking a smaller car loan to buy either a used or off-lease vehicle instead.
Alternately, if your dealer offers a leasing program, you could consider leasing (like renting) the car and, when the lease term is up, negotiate a buy-back agreement with the dealer. The buy-back value may be within your budget. Even if you do need a loan to buy it, the financing cost will be more favorable than seeking a larger car loan for a new vehicle.