One of the biggest mistakes people make when buying a new car is forgetting to include the cost of auto financing in the total price.
For example, if you’re buying a new Honda Civic, the difference between “sticker price” and the dealer’s invoice price (what the dealer paid for the car) is about $1,500. If you negotiate well, you could save $1,000 or more on the price of the car.
If you then finance the car for four years at six percent with nothing down, you’ll pay over $2,000 in interest. Financing the car for three years at four percent with a $1,500 down payment, however, can save you over $1,000.
If you’re willing to negotiate the price of the car, you shouldn’t ignore the rates and terms of your financing. I made this mistake the first time I bought a car and vowed never to do it again.
If you’re in the market for a new car, don’t wait until you’re in “the box” (what some dealers call the offices where you finish the paperwork) to think about your financing.
Auto financing tips
You car is not an investment. Quite the contrary: Cars depreciate like crazy. For this reason alone, it’s not smart to pay interest on a car loan. What happens in most cases is that the car depreciates and the value of the car drops faster than you repay the loan, leaving you upside down or underwater (when you owe more on the loan than the car is worth).
That said, many of us need cars to get to our jobs and don’t have the cash lying around to buy a reliable ride. So we get a car loan. That’s cool, but there’s a difference between using a car loan wisely and using it to buy a lot of car you can’t afford.
I have the credit and income to go out and get a loan for a BMW M3. And I would love that car. But that doesn’t mean I should get it. What the dealerships will tell you you can afford and what you should spend are two very different things. Use our car affordability calculator to see what you can afford.
Whenever you finance a car, you want to think about it not just in terms of the monthly payment, but also in terms of the total cost. Here’s what I recommend:
1. Understand your credit score before you go to the dealership
If there’s ever a time to check and track your credit report and score, it’s before you get a car loan.
Here’s the deal: Unlike mortgages or a credit card, you can usually get a car loan even if you have pretty bad credit—you’ll just pay (a lot) more. The reason? It’s relatively easy for the banks to repossess a car if you don’t pay.
But if you have shaky credit, you’re likely excited to even get a loan, so you’re not going to want to ask if there’s a lower rate available. Dealers know this and they make a lot of money on it.
Free tools like Credit Karma can help you understand your credit score. Once you know your credit score, you can figure out if you can qualify for the best car loan rates.
Dealerships will often advertise very good interest rates on new cars: 2.9 percent, 1.9 percent, sometimes even 0 percent. What they leave in the fine print is that these rates are only available to buyers with the best credit—that may mean a FICO score of 750 or better.
Buyers with credit scores in the low 700s can still get a good interest rate but may not qualify for the best promotions. After that, rates rise quickly. Borrowers with below average credit scores (under 650) may be presented with car loan rates of 10 percent or more.
The lower your credit score, the more important it becomes to shop around and make sure you’re getting the best rate a bank can offer you. Yes, you may have to pay more than someone with good credit, but you may not have to pay the first rate somebody offers.
2. If your credit isn’t perfect, get financing quotes before you go
If you have excellent credit and you know it, you can usually get the best financing rates right from the dealership (who serves as a broker for multiple lenders).
Don’t have stellar credit? Try online lenders. You complete a credit application and are presented with your interest rate and a max amount you can spend on the car. The nice thing is you don’t have to use this loan if the dealer gives you a better deal, but at least you can walk through the door knowing that you have an interest rate to beat.
One of our favorite loan matching services is EVEN Financial. When we were considering partnering with them, we tried their services and found that they provide the lowest-cost loans based on your individual needs and situation. You can read our review or try them out yourselves.
Most of the time, local banks and credit unions can offer borrowers with average credit the most competitive interest rates on both new and used car loans. Even better, you may be able to use the pre-arranged financing as a bargaining chip with the dealership’s finance and insurance (F&I) manager and score an even lower interest rate.
3. Keep the term as short as you can afford
Shorter loan terms come with lower interest rates but higher monthly payments. And that’s what you want.
When you walk into a dealership and say you want to finance your car, any savvy car salesperson will try to negotiate with you you based upon your monthly payment, not the overall purchase price of the car. By doing so, the sales rep can show you lower and lower payments by extending the the term of your loan, not by reducing the price of the car. Suddenly a $470 car payment becomes a $350 car payment. And yet you’re not paying any less for the car. In fact, you’ll be paying much more in interest.
The longer you take to repay a loan, the more interest you’ll pay. But that’s not all. Many times banks will charge higher interest rates for longer loans, further increasing your cost of credit.
It’s tempting to stretch out an auto loan over five or even six years to get to a more comfortable monthly payment, but this means you’ll pay a lot more in interest and almost certainly be upside down on your car for nearly the life of the loan.
4. Put 20 percent down
In addition to a short loan term, you can avoid a situation in which you owe more money than the car is worth by putting money down.
This may seem like a no-brainer, but many dealerships don’t even require buyers with good credit to make any down payment at all.
Driving off in your new car without putting a penny down is tempting, but it’s risky. If you find yourself suddenly needing to sell your new car, you may not be able to if you owe more on the loan than the car is worth. A larger down payment ensures this doesn’t happen.
5. Pay for taxes, fees, and “extras” with cash
Do not finance the miscellaneous expenses involved in your vehicle purchase such as sales tax, registration fees, documentation fees, and any extras you choose to purchase like extended warranties.
Often, dealers are more than happy to roll some or all of these fees into your financing. Unfortunately, doing that just ensures you’ll be upside down on your car loan, at least for a while, since you’re increasing the amount of your loan but not the value of the car securing the loan.
Other considerations when financing a car
Gap insurance (guaranteed auto protection insurance) is something car dealers and lenders sell you to cover the “gap” between what an insurance company thinks your car is worth and what you owe on your car loan in the event you’re in an accident and the insurer declares the car a total loss.
Without gap insurance, your auto insurer will only pay book value for the car, regardless of what you owe on the loan. If you crash your car and still owe $12,000 on your loan, but the insurance company only covers the car for $10,000, you’re responsible for paying back the $2,000. (And you’re without a car.)
People buy gap insurance out of fear because nobody wants to owe a couple of thousand on a totaled car. But if you structure your car loan correctly (put money down and stick to a three-year term), you can feel confident that you won’t need gap insurance because your car shouldn’t be worth less than what you owe.
Prices for gap insurance vary widely (from $30 or so a year to over $600 for the term of a car loan). The policies the dealers offer may be the most expensive, so if you feel like you need gap insurance, contact your auto insurance agent.
When to refinance a car loan
Let’s say you didn’t see this article in time and got stuck with a really bad car loan. No big deal. If your credit is good and your car isn’t too old, you should be able to refinance your car loan just like you can refinance a mortgage.
It’s easy to get auto loan refinancing quotes online with no obligation. LendingTree is a trusted site that offers four to five quotes with one easy application. A local credit union is also a great place to check out options for refinancing your car loan.
Wherever you go, ask about any fees for applying or initiating the loan and avoid lenders who want to lower your monthly payment by extending the term of your loan. With an auto loan refinance, you want to get a lower interest rate and pay down the loan over the same or a shorter term.
Unless you’re looking at 0 percent or another really low APR, the best way to buy a car is with cash. If you have to get a car loan, be as pragmatic as possible.