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The Simple Dollar Guide to Auto Loans
Getting an auto loan isn’t as tricky as securing a mortgage since the lending criteria are a bit more flexible. But you still want to begin with a good idea of what you can afford — especially before falling for a budget-busting vehicle and committing to a car loan that stretches you too thin.
According to CNBC, about 14.5 million new cars and light trucks were sold in 2020, down 15% from 2019, likely due to COVID.
This car loans guide includes a basic primer on what you can expect from the auto loan process, including how to qualify for a loan, where to obtain one and whether refinancing is a good idea.
What is a car loan?
What does it mean to finance a car? Most people who buy a car don’t always have the full amount to pay upfront. Instead, they choose to take out funding to help pay for the cost of the car. This is an auto loan. Auto loans are agreements with banks, credit unions, dealerships or finance companies to borrow the money to pay for your car in return for paying that money back with interest over time.
While auto loans are generally not free, they are powerful tools that can help get you behind the wheel of the car you want without having to wait years to save up the money you need.
How to finance a car
The process of getting a car loan is not a lengthy one. If you are interested in getting an auto loan, following these steps can help get you behind the wheel of a new car.
- Determine how much you can afford. Determine how much you can afford to pay for a car before you begin applying for loans. Remember, your monthly payment amount will include the principal and interest, but you want to consider any fees and payments made at the time of purchase, such as down payment, taxes, and title fees. The Consumer Finance Protection Bureau also recommends to factor in all costs of car ownership, including insurance, maintenance and fuel.
- Shop for an auto loan Between auto dealers and manufacturers, banks, credit unions and online lenders, you have a lot of different deals you may encounter. It wouldn’t hurt to shop around to ensure you are getting the best deal available.
- Negotiate Once you begin the process of applying for the loan, consider negotiating the terms of the loan and the price of the vehicle. There is a chance you can get the car for a lower price or even get a lower interest rate. It doesn’t hurt to ask.
- Get approved After agreeing on the financing terms, you can officially be approved for the loan and move forward with signing the paperwork and getting the keys to your new car. Be sure to double check the paperwork to ensure it reflects the terms that were agreed upon.
Guide to auto loans
If you’re new to the car buying process, you may be wondering what determines whether you can get a loan, what your interest rate will be, and how much you’ll pay back in the end. There are several factors at work, so here’s the scoop on how lenders size you up.
Your credit history and debt load
The almighty credit score is one of the most important things a lender will consider when deciding whether to extend an auto loan. The better your credit score, the more likely you’ll be approved, and the lower your interest rate will be.
[ Read: What’s a Good Credit Score? ]
A lender also wants to make sure you aren’t already burdened with too much other debt — if you are, that increases the chances that you’ll have trouble paying back your loan. Lenders calculate a number called a debt-to-income ratio, or DTI, which is simply how much of your monthly income is eaten up by your various debts, like student loans and minimum payments on credit cards. Every lender is different, but many want this number to be 40% or less, meaning that if you make $4,000 a month, your debt payments — including the car loan you’re applying for — should total no more than $1,600 per month.
Your down payment
The down payment is how much money you are willing to pay upfront for your car. It reduces the principal of your auto loan — that is, the amount you have to borrow. If you want to buy a $20,000 car and have a $5,000 down payment, your loan principal will be $15,000.
Bigger is often better when it comes to down payments. When you’re buying new, putting down at least 20% of the purchase price is ideal because it helps make sure you don’t start out owing more than your car is worth — remember, cars depreciate by as much as 25% in the first year of ownership. If you’re buying a used car, you should still aim for at least a 10% down payment. And if your credit score isn’t great, a bigger down payment will give you more leverage to negotiate a better interest rate.
The loan term
Your loan term is simply how long you get to pay back the lender. A term of anywhere from three to six years is common for a car loan, but you can also find shorter or longer terms.
[ More: Best Auto Loan Rates of ]
If you spread your loan over a longer-term, you’ll have a lower monthly payment. The catch is you’ll end up paying more in interest, which means the car will cost you more money in the long term.
For example, you could borrow $15,000 at a 4% interest rate with a three-year term and pay back roughly $15,943 overall. Double your term to six years and you’ll pay back $16,897 total, almost $1,000 more. As long as you can afford the higher monthly payment ($443 vs. $235), the shorter term is the better deal.
The vehicle you want
Your loan principal will usually be lower for a used vehicle since the car’s price will be lower, but you can get a better interest rate on a loan for a new car. There are a few reasons why: It’s harder for a lender to resell a used car if you default on your loan, and many lenders also prefer to steer you to a pricier new car, as they’ll rake in more interest. Finally, people with lower credit scores are more likely to buy a used car, and lenders charge them higher interest rates to offset the extra risk.
[ Related: Best Bad Credit Auto Loans ]
Where can I get an auto loan?
Almost every major lender offers auto loans. Lenders like car loans — after all, it’s pretty easy to repossess a car if you stop paying. But just because you can get a loan anywhere doesn’t mean you should; consider the pros and cons of your options first.
Dealers and car manufacturers
You’ve gone to the car dealer and fallen in love with the car. If you don’t have financing yet, a dealer will be more than happy to arrange it for you. This is definitely convenient, but be careful. A dealer works with a network of lenders to arrange financing, but may mark up the rate from what you could get if you went to those lenders yourself.
You may also be able to get a loan from the lending arm of your car manufacturer — for instance, Honda Financial Services or Ford Credit. It’s typical to also arrange these loans through your dealer, though you may also apply directly online. Car manufacturers often offer special promotions that can save you a lot of money — as long as you can qualify.
Banks or credit unions
You can also head to your local bank or credit union to get pre-approved for a car loan before setting foot on the dealer’s lot.
[ More: The Best Banks of 2020 ]
It may be more convenient to get pre-approved at a bank where you already do business — after all keeping your accounts in one place is convenient. But don’t discount credit unions, which may offer slightly lower interest rates thanks to lower overhead. Credit unions may also be more flexible with lending criteria, which can be important when you don’t have great credit.
What could be more convenient than getting a car loan at home in your pajamas? That’s the major selling point of going with an online lender, though some may also be able to offer lower interest rates because they don’t incur the overhead costs that brick-and-mortar banks do. Just be sure to do your homework online — only fork over your personal information if you’re sure the lender is legit.
Whatever you do, get pre-approved
You may well end up with a loan from the dealer, and there’s nothing inherently wrong with that. But getting pre-approved by a lender before you go car shopping is one of the best things you can do. Why? Several reasons:
- You have a bargaining chip: You don’t need dealer financing, but the dealer still wants that piece of the pie and may offer better terms to retain your loan and the profits it will generate.
- You’re more likely to stick to your budget: It’s common for dealers to ask you what you want to pay each month, then work the numbers so that you can suddenly “afford” a more expensive car — often because they’ve stretched out the loan term over a longer period. You’re less likely to fall for this trick if you have a concrete offer for an amount and term that fits your budget.
- It makes car-buying less stressful: Buying a car can be a truly uncomfortable experience for people who hate negotiating. Getting pre-approved can help ease some of that stress, letting you focus on getting a better deal on the purchase price of the car itself rather than haggling over the loan.
Average APR for car loans
What can you expect to pay in interest on your auto loan? Remember, it will vary widely due to a number of factors. Better credit, a lower debt-to-income ratio, a shorter loan term, a higher down payment, and buying new instead of used are all factors that can help you secure a lower interest rate.
According to the Federal Reserve, the average auto loan interest rate on a 60-month auto loan was 4.96% in February 2021. This is a decrease from 2020, which saw average auto rates above 5%.
[ More: The Best Auto Loan Rates of 2020 ]
Because auto loans are secured loans, meaning the car is collateral, you can expect lower interest rates than you would see on a personal loan. Auto loan interest rates typically start around 1.99% and are capped around 20%. However, you have to have the best credit and most favorable terms to secure an interest rate of 2% or lower.
Current auto loan rates
|Lender||New Car APR||Used Car APR||Refinancing APR|
|Bank of America||as low as 2.19%||as low as 2.39%||as low as 3.19%|
|Navy Federal Credit Union||1.79%–5.59%||1.79%–5.59%||1.79%–5.59%|
|LightStream||as low as 2.49% w/Autopay||as low as 2.49% w/Autopay||as low as 2.49% w/Autopay|
|Alliance Credit Union||1.99%–4.50%||2.25%–3.50%||2.25%–3.50%|
|Safe Fed||as low as 1.99%||as low as 2.99%||as low as 2.99%|
*Rates accurate as of October 2021.
What about 0% financing?
If you have top-notch credit, a lender — typically the financial arm of the vehicle’s manufacturer — may offer you a 0% interest rate deal. It seems too good to be true, but it’s usually a legitimate deal. Of course, there are few things you’ll need to consider:
- You might not qualify. These deals are reserved for a small subset of would-be customers with the best credit. If you’re sucked in by the possibility of 0% but offered a higher rate, make sure it’s still competitive.
- The repayment term might be short. Some 0% financing promotions are only offered for shorter loan terms, such as 36 months. You will pay less in the long run, especially with 0% interest, but you’ll have higher monthly payments. Make sure you won’t break your budget going for this deal.
- You may not have as much wiggle room on price. A dealer that isn’t making any money on your loan may be less willing to discount the cost of the vehicle itself or may try very hard to sell you on extras and upgrades.
- You may have to forgo rebates or other promotions. It’s common for dealers to make you choose between 0% and a deal such as a manufacturer’s rebate that shaves off a certain amount from the price of the car. You’ll need to do the math to figure out which is the best deal — it might ultimately be better to take the rebate and get a low-interest loan instead of a marginally better 0% rate.
[ More: What Are 0% APR Auto Loans? ]
The cost of buying a car
There’s more to consider than the sticker price of a car when it comes to getting an auto loan. Here are the associated costs you won’t want to ignore:
- Sales tax: Of course, you’ll still be charged standard sales tax on your vehicle, and that’s no small chunk of change on a new car. If you’re paying 7.5% sales tax on a $25,000 car, that’s $1,750.
- Title and registration: This makes your new wheels legal. It varies dramatically by state — some places, you’ll pay less than $50; others, you’ll pay more than $200. Fees may also vary depending on the age and weight of your vehicle.
- Dealership/documentation fees: Your dealer may add these fees to cover the cost of preparing paperwork, shipping a car to the lot or prepping a car for sale. Certain states cap this fee, but most do not. Make sure your dealer isn’t charging you a fee that is significantly higher than the state average. Unlike tax, title and registration, these fees are negotiable.
- Insurance: You likely won’t be able to close on your auto loan unless you can show proof of insurance. If you’re not already an insured driver, this is an additional expense you’ll need to budget for and cannot be included in your car loan. See our guide to the Best Car Insurance Companies and Best Cheap Car Insurance for the basics.
- Extras: When you’re finalizing your purchase, the dealer will probably try to sell you several extras. Common options include rust-proofing, paint protection and extended warranties.
Pretty much everything but insurance can be rolled into the cost of your loan, but take note: Aside from boosting your payments, doing so increases the likelihood that you’ll initially owe more than the car is worth, especially if you don’t make a sizeable down payment. That could leave you owing a bunch of money on a worthless car if you get into an accident.
Auto loans for bad credit
Buying a car when you have bad credit can be frustrating, but it’s certainly not impossible. While you may have to shop a little harder because of fewer options and higher prices, buyers with bad credit can still get into a good car.
If you don’t need a car right away, you can always look into building up your credit before you need to buy. If you need to get into a car right away, consider paying for as much of the car upfront as possible. This limits how much you need to finance. If that’s not an option, consider a less expensive car or see if a friend or family member is willing to cosign for you.
Used vs. new car loans
Depending on whether you’re getting a brand new car or a used car, the characteristics of your loan may be quite different. First, used car loans generally carry a higher interest rate than new car loans. Second, depreciation on a used car is generally much slower because someone else has already driven the car, so the initial steep depreciation has already occured. What this means for your loan is that it will be much easier for you to protect yourself from becoming upside-down on the loan.
[ Next: The Best Used Car Loans ]
And lastly, while there are a lot of differences between used and new car loans, the importance of paying off the loan on time is still the same. The effects on your credit and the risk of repossession are the same no matter the type of car you purchase.
When to buy a new car
- When you can afford it: No matter how good the sales and deals are out there, the best time to buy a car is when you can afford it. Have a financial plan for the purchase and also the repayment of the auto loan before moving forward with any deals.
- Major holidays: Car dealerships love to run huge sales on major holidays. Because the dealership is planning to move higher volume, they are often willing to come down on price and offer great incentives to get you in the door. Examples include Christmas, Labor Day and Memorial Day.
- End of the month: Many car dealerships have quotas they need to hit every month for sales. When it gets close to the end of the month and a dealership is short, it might try pushing some bigger deals to get over the mark. But if the dealership is already at its quota, this gives it some leverage to hold out on deals.
[ More: The New Car Buying Guide ]
Refinancing your auto loan
When you refinance your auto loan, you obtain a new loan and use it to pay off your old one. Borrowers who choose to refinance typically do so to get a new loan that has better terms (typically a lower interest rate) than their old loan, meaning they save money in the long run. Alternatively, some people who can no longer afford their monthly payments refinance into a longer-term loan to lower their monthly payment.
[ Related: Should You Ever Refinance Your Car Loan? ]
When should I refinance my auto loan?
Refinancing auto loans isn’t as common as refinancing a mortgage — since the loan amount is not as high and interest rates often start out lower, the savings aren’t as dramatic. Still, it’s worth considering under the following circumstances:
- Your finances have improved substantially. If you’ve cleaned up your credit and/or paid down a substantial chunk of debt, you may qualify for a much lower interest rate than what you originally obtained.
- Rates have gone way down. Maybe you had great credit to begin with, but you still see that rates have fallen and want to take advantage.
- You can’t keep up with your payments. Perhaps you got a short-term car loan or a more expensive car, thinking you could handle the high monthly payments. If that’s not the case, instead of going into default, see whether your lender will work with you to alter your loan terms or refinance into a new loan with payments you can afford.
What to watch out for when refinancing an auto loan
If refinancing sounds good, keep in mind that your car should be newer and in good condition. Lenders want your car to be valuable enough to resell if they need to repossess it. That means it will be hard to get a new loan on a vehicle that’s more than a few years old, or one with excessive mileage.
If you’re refinancing to lower your monthly payment, make sure you understand that doing so will both lengthen the amount of time you’ll be making payments and raise the amount of interest you ultimately pay back. Having the loan for longer may also affect your ability to obtain other loans.
You’ll want to ask what kind of fees the lender will charge to refinance — though they aren’t usually terribly high, they can still eat into savings. Also, check your existing loan for any kind of prepayment penalty. These are rare, but if your loan has them, they could make refinancing too costly.
How to refinance your auto loan
- Find out your payoff amount. The first step to refinance your current auto loan is to find out exactly what you owe. You can contact your lender and get a payoff amount by phone or online.
- Check your credit score. If your credit situation has gotten better, you could have the opportunity to finance a better loan. Additionally, with where rates have moved recently, you could find a great deal. But you’ll need to know where you are at credit-wise to know what may or may not be possible.
- Start shopping options. Take the time to start looking at what different lenders may be willing to offer you. Check online lenders, banks and credit unions. Additionally, you could always check with your existing lender to see if it have any options. Sometimes a lender may offer you a few added perks to keep your business in-house.
- Don’t stop making payments. During the shopping process, you’ll want to stay on top of your existing loan payments until your new lender pays off your old auto loan. Then, you can start making payments to your new lender.
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