A Beginner's Guide to Auto Financing

Whether you are buying a new or used vehicle, you have two options: pay the full purchase price upfront, or make payments over time.

While personal finance gurus may suggest trying to pay for your car in cash, that may not be feasible for every American in need of new wheels. In fact, as of 2017, 44 percent of adults in the United States had an auto loan — that’s more than 108 million car loans in the country, a number that has been trending up since 2012 (see chart below).

"Auto financing can be a headache," says Will Craig, managing director and CEO of LeaseFetcher, "particularly if you have a challenge with debt." If you are unfamiliar with the process, or you are a first-time car buyer, understanding your financing options can make or break your financial situation for years to come.

“If you go to a dealership,” says Michael Rudge at Rudge Automotive and Paytons Auto Body, “NEVER get sucked into the payment conversation: "What would you like your payment to be?" It's financial suicide.”

How do we avoid car shopping mistakes like this? 

LeaseFetcher's Craig instructs, "When it comes to auto financing, knowledge is definitely power. The more information you have about auto finance, the better chance you'll have of being able to find the right loan for your circumstances." 

If you’re in the market for a car, start with these three essential steps:

1. Know your credit score

“Start with your credit score,” suggests Sonia Steinway from Outside Financial. “Auto loan interest rates depend on the borrower’s credit history and score. The higher your credit score, the lower interest rates you should expect because lenders view lending you money as lower-risk.

Your credit score doesn’t just change the interest rate; it can also mean the difference between being approved and declined. Many lenders won’t lend money to anyone with a credit score below a certain number.

By law, you can access each of your credit reports for free once a year at annualcreditreport.com. Before you car shop, make sure yours is accurate and up-to-date. Most auto lenders prioritize a borrower’s history with car loans specifically, so a first-time car shopper may want to ask a close friend or family member to be a co-borrower to secure a better interest rate.”

Your credit report will affect the annual percentage rate of the loan. Check out these images from Wallet Hub illustrating the difference between loan percentage rates for consumers with excellent and fair credit scores.

Source: WalletHub

Even having a fair score increases the percentage rate, not to mention what a loan looks like for someone with poor credit

Please remember that with any lender, rates and terms for your loan, including your monthly payment, will depend on whether you have good credit or bad. The lower your credit score, the higher the interest rate. (see image below)

As knowledge is power, knowing your score is essential. LeaseFetcher's Craig says, "Companies use [your credit score] to assess how much of a financial risk you might be when it comes to repaying debt so it makes sense to get this in good health before you start applying for finance. Gather information about your credit score and take steps to improve it before you even start looking for finance for the car. Your bank balance will thank you in the long-run."

2. Create a budget

Once you know your up-to-date credit score, your next step may require a little homework. “Know what you can spend in a month,” suggests Jake McKenzie from Auto Accessories Garage. “If you plan on buying your first car and financing it, you may have never made a comprehensive budget. But if you want to know what kind of car you can afford, having a budget beforehand is essential.” Knowing how to account for your monthly car payment in that budget is essential.

“It’s important to know what you can afford and stick to that budget,” advises Ivan McBride, vice president of automotive lending products and sales at PenFed Credit Union. “You don’t want to take on a payment or loan term that does not fit your budget.”

So, how much of your budget should you set aside for a down payment? What about a monthly payment?

Valerie Coleman, an auto expert previously with AutoTrader and now with 5miles.com, explains, "The generally accepted rule is to spend no more than 15 percent of your pre-tax income on your monthly car note. And always assume a downpayment. Be prepared to put $1,500 down, for example, on a vehicle that costs between $23,000 and $34,000 (e.g. good buys like Chevrolet Malibu, Mazda 3, Nissan Rogue, Subaru BRZ, Toyota Prius)."

3. Explore your lending options

Auto financing is available from several different sources, including community, regional, and national banks and credit unions, car manufacturers themselves (for new models), and in-house financing set up through the car dealer in the finance office. Car buyers should know that dealership financing means that your loan package can be marked up by about $1,700 on average, according to Outside Financial. A typical dealer finance package markup includes $250-$2,000 added to your loan, as well as fees for things like a service contract or extended warranty and GAP insurance.

What will interest and repayment terms be like for a car loan? Of course, these will depend on the financial institution you decide to go with, whether you have good or bad credit, how much of a down payment you can afford, the cost of the vehicle, and many other factors.

McBride says, “According to ValuePenguin the average interest rate for a 36-month term auto loan is around 3.71 percent APR. Most manufacturer financing is pretty competitive since they’re up against banks, but consumers should also look to credit unions. PenFed offers an auto loan as low as 1.49 percent APR on new cars through TrueCar.”

Check out this graphic from WalletHub, showing the differences between several car finance options and terms, when it comes to buying a car with different lender types.

Source: WalletHub

"Finally, shop price and not payment," advises auto sales expert Valerie Coleman, from 5miles.com. "Payments can be deceiving when stretched out for up to 84 months. Utilize all of the online resources available. There are sites out there that compare prices for vehicles, looks at total cost of ownership, reviews, recalls, vehicle history and alternate vehicles to consider. Approach a car as a commodity and avoid having an emotional attachment (even if it’s your dream car). This will give you the best ability to negotiate and be an educated consumer."