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.
This car loan 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.
Key Factors That Determine Your Car Loan
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. If you need a primer on improving your credit score and why it matters, check out “What Is a Good Credit Score?” for the basics.
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. They’ll 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.
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.
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. They 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.
It may be more convenient to get pre-approved at a bank where you already do business — after all, they know you, and keeping your accounts in one place is convenient. But don’t discount credit unions, which may offer slightly lower interest rates thanks to their lower overhead. Credit unions may also be more flexible with their 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.
What Kind of Interest Rate Can I Expect?
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 myFICO, the national average for a $20,000, 48-month car loan for buyers with excellent credit as of mid-January 2016 was 3.28%. Remember, however, that auto loans are extremely competitive, and it’s not uncommon for buyers with excellent credit to secure even lower interest rates.
If your credit is average or poor, however, kiss that sweet interest rate goodbye. A middling credit score of 650 could mean an average interest rate of 9.32%, according to myFICO. A poor credit score in the 500s could mean a rate approaching 15% — no better than most credit cards. At a rate like that, for the same car, you’d be paying more than $100 more a month than someone with excellent credit, and more than $6,500 more over the life of the loan.
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 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 that won’t put too big a squeeze on your budget.
- 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% or otherwise low-interest financing 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.
Other costs to remember
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 (mostly unnecessary) 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 Loan Glossary: Terms to Know
Need a quick primer on some unfamiliar auto loan terms? Here are a few you’re bound to encounter.
The APR, or annual percentage rate, is what you’ll pay yearly for your car loan. It can be slightly higher than your interest rate because it includes everything you finance, including any extra costs and fees.
If your credit is poor or you don’t have a long credit history, you may be able to get a better car loan with a co-signer. The co-signer, who must have excellent credit, legally agrees to pay your loan in the event that you default — a potentially sticky situation that should make co-signing a loan a last resort.
This is a numerical representation of your creditworthiness, including how long you’ve had credit accounts, how responsible you’ve been about making payments, and the amount of credit you’re using. Lenders look at this number to determine whether they should lend to you, and if so, what kind of interest rate you should get. Borrowers with higher credit scores present less risk to the lender and thus receive lower interest rates.
Lenders also look at how much debt you’re already on the hook for each month as they decide whether to lend you money. The debt-to-income ratio tells them what proportion of your income goes toward debt payments each month.
A down payment is the amount of money you pay upfront. A bigger down payment lowers the amount you have to borrow — the principal of your loan — and thus lowers your monthly payment. Sometimes a lender will give you a better interest rate if you make a bigger down payment.
Equity is how much of your car you actually own. For instance, if you make no down payment and finance the entire purchase, at first you’ll have no equity in your car whatsoever. The longer you make payments, the more equity you build up.
The interest rate is what you pay the lender yearly in exchange for borrowing money. But unlike an APR, it doesn’t include fees and other costs you may also pay with your loan.
Your loan’s principal is simply the amount you originally finance with your loan. It doesn’t include interest.
A rebate is an amount that the dealer will knock off the price of your car. Typically, this becomes part of your down payment if you’re using an auto loan, though you can also opt to receive a check for the rebate. Sometimes you’ll have to choose between promotional incentives, such as between a very low-interest rate or a $1,500 rebate.
The loan term is how long you get to pay back your auto loan. Three to five years is common, but you can negotiate shorter or longer terms. Shorter terms mean higher monthly payments, but you’ll pay much less in interest overall; longer terms mean lower payments but more interest, raising the long-term cost of your loan.
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.
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
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.
Auto Loan FAQs
Need some quick answers about financing a car? Below, you’ll find answers to some of the most common questions about auto loans.
How can I land the best interest rate on my auto loan?
The most important factor is credit — if your credit score isn’t great, you may want to work on raising it before going car shopping, if you have the luxury of time. Don’t know where to start? Check out “What is a Good Credit Score?” for tips.
You also don’t want to overlook the importance of shopping around. Car loans are a very competitive business, and few lenders will pass up the opportunity to beat a competitor on rates as long as you can meet their underwriting standards. Start by looking at interest rates online, but don’t assume you’ll be able to get the lowest advertised rate unless you have top-notch credit.
Will I still be able to get a car loan if I have bad credit?
Chances are good that you can still get a car loan, even with bad credit. Underwriting standards aren’t as strict with car loans as they are with other loans such as mortgages and personal loans. However, you will probably have a much higher interest rate. That will make it even more essential to shop around. For tips on getting a car loan with bad credit, see our guide to the Best Bad Credit Auto Loans.
How is the APR different from the interest rate?
You’ll want to compare the APR, or annual percentage rate, on different loans instead of the interest rate. That’s because APR takes into account other fees and costs associated with the loan, while the interest rate is simply what it costs to borrow the principal each year.
What happens if I fall behind on car payments?
If you only miss one payment, chances are you’ll simply be stuck paying some sort of late fee, as long as it’s been less than a month. Go longer than that and your lender will probably report the late payment to the credit bureaus, and your credit score will go down because of it. You may also start getting calls from your lender.
Go more than a few months, and your lender may declare you in default, sell your loan to a collection agency, and attempt to repossess your car in order to recoup some of the money it has lost.
Why should I avoid a long-term auto loan?
As we mentioned earlier, the easiest way to afford a more expensive car is by spreading out the payments over a longer period of time, or term. Unfortunately, this also means you pay a lot more for your wheels in the long run.
Aside from paying more for your car, remember that lengthening your loan term means you’re committing yourself to debt payments for longer than might be necessary. That additional debt means you may have a harder time qualifying for a mortgage or other loans, and it can also make it harder to save money, whether that’s for a short-term emergency fund or your eventual retirement.
Can I make extra payments on my auto loan?
When you have a little extra cash to pay towards your auto loan, make sure to specifically request that the extra money is applied to the principal of your loan instead of treated simply like an “extra” payment. By chipping away at the principal, you’ll be saving on interest, which is based on your outstanding loan balance.
Some lenders don’t make principal-only payments an easy process — after all, they want you to hold on to the loan as long as possible so they can keep raking in interest. Be sure to ask your lender how to make such a payment, follow their instructions, and double-check your statement to make sure they kept their word.
What is gap insurance, and do I really need it?
While cars are a necessity for most of us, you won’t want to think of them as a good investment. A new car’s value plummets up to 11% when you drive it off the lot, and up to 25% by the time you’ve owned it for a year. After three years, your car has lost nearly half its value.
One of the biggest potential problems with this rapid depreciation is when you make an auto insurance claim. If you total your car a year after you buy it, your insurer is typically only going to pay its cash value. Unfortunately, your loan balance could be greater than the car’s value, and you’ll be on the hook for the rest.
You can purchase what’s called “gap insurance” to cover that difference — but that’s still an extra expense. Instead, if you can, make a big enough down payment to help protect yourself.
For instance, if you make a $5,000 down payment when you purchase a $20,000 car, you’ve already compensated for that potential 25% loss in value and don’t need the gap insurance.
Why shouldn’t I shop according to what I can afford each month?
In addition to how much you can afford each month, you should focus on the overall cost of the vehicle while you’re shopping. If you tell a dealer what you want to spend each month, it’s very likely that they’ll try to hook you on a pricier vehicle and simply lengthen the loan term to lower the payments. Then you’re stuck paying off your car for a longer time than you wanted simply to keep the payments within your budget.
I was told I don’t need to make a down payment — is that a good idea?
Not usually. Making a down payment helps keep you from being “upside down” on your car loan, which is owing more on the loan than the car is worth. Since cars lose value so rapidly, this could put you in a real bind if you want to sell the car or get into an accident and your insurer will pay only the current value. In either scenario, you’ll actually have to pay out of pocket the difference between your car’s value and your loan balance. If you’d started out by making an adequate down payment, you won’t have to deal with this shortfall because you’ll already have some equity in your vehicle.