Different Types of Car Financing
I know how it feels to look for financing. The process of financing a vehicle and its down payment can often feel overwhelming.
However, spend a little time understanding the different types of car financing available.
You'll be able to explore all your options instead of depending on the dealership only.
The three most popular options include third-party bank loans, credit union loans, and dealer financing.
1. Bank Loans
Going to your bank for vehicle funding typically involves taking out a loan that must be paid back monthly. This would include interest rate charges that vary based on individual factors and will incur a hard inquiry on your credit score. Bank loans typically require a minimum of 600 credit score to finance, but it will vary by lender.
As mentioned already, your credit score will determine your interest rate. Anything over 780 is a good credit score. Dealer financing might be a better option if you have a bad credit score.
2. Credit Unions
Credit unions provide another solution to consider. But you might face some challenges if you have a bad credit score. Like bank loans, you will have a hard inquiry on your credit to see what you qualify for. The major benefit of a Credit Union is the lower interest rates. However, these financial institutions are smaller and may have limited options.
Credit Union Loans
Credit Unions are non-profit financial institutions. They offer Credit Union Loans to their members. They have attractive terms and rates compared to traditional lenders.
Those who meet their eligibility requirements have options for new and used cars. Plus, personal service and flexible repayment options.
This will be a great option if you have good to excellent credit, as data shows they are more stringent in qualifying for an auto loan.
However, each Credit Union has different guidelines. It is best to review your options before applying.
These loans are not just for cars. They can also be used for home improvement, education, or debt consolidation.
For example, my neighbor was a member of a local credit union in NJ. He secured a low-interest-rate loan and got his dream car without breaking the bank.
Here is a listing of all the credit unions in New Jersey.
Credit Union Loans are a great way to get auto financing, especially with lower interest rates and personal services.
3. Dealer Financing
The most popular option is dealer financing. This is where you secure financing at the same dealership where you buy your car or vehicle.
While you have the convenience of a one-stop shop, interest rates are typically higher than a bank or credit union.
Here's what you need to know regarding dealer financing:
- Dealerships partner with banks and lenders for loans or leases. (They do the work)
- Interest rates are calculated based on your credit score.
- Dealerships often offer incentives like zero-interest loans or cashback. (Those who qualify)
As I said, dealership financing can be more expensive than banks or other lenders.
Why?
Dealer financing is a profit center for dealerships. They may markup the rates based on what they are getting the loan for, thus making a little more money. NerdWallet reported that some dealerships could make thousands of dollars via their point markup.
It depends on your financial situation and resources. Researching options before shopping for a vehicle can help you secure outside financing with lower interest rates.
Sadly, some buyers have paid higher interest rates due to car sales pressure tactics.
Be sure to check the contract and the line items before signing the financial papers.
Understanding Interest Rates and Loan Terms
Let's take some time to better understand interest rates and loan terms in financing a car.
I will review the annual percentage rate (APR) and things to consider with the length of the loan.
The APR is the rate charged on the unpaid balance of your loan.
The average APR is hovering around 5% - 6%. (Circa 2023) Rates might have fallen or risen by the time you read this.
The lower the rate, the better. You can sometimes find APR at 0% - 0.9% for qualified buyers by various brands.
What is a Good Annual Percentage Rate (APR)?
Interest rates are the most important number to remember when taking out loans. This will impact the total cost you will end up paying. This number is usually expressed through an Annual Percentage Rate (APR). You have to keep in mind that this is interest that is paid per annum.
For example, if you borrow $20,000 at 5% APR, you will pay back $26,356 ($1,000 in interest payments per year for 5 years) plus any additional fees.
You can check out a free Auto Loan Calculator to see how your numbers work.
Be aware that APR differs between lenders and can be based on factors such as credit score, loan amount, and term duration.
So, always compare APRs from various lenders before finalizing your decision. A 0.5% point can be a difference of thousands of dollars over the life of the loan.
For example, my cousin had two loan options with varying APRs. Despite the same loan amount, he had different payment terms – which heavily influenced the APRs. Using a loan calculator – he made a wiser decision to take the short loan term with a lower interest rate. He still had larger monthly payments but will come out ahead in the long term.
Length of Loan
In addition to the APR or interest rate, the length of your loan will determine the total amount of interest you'll pay over the life of your loan.
Let's take a look at how time influences the total payment. (Remember, each additional year will add the annual interest to the balance)
- Longer terms mean lower monthly bills but more interest paid overall.
- Shorter terms result in bigger payments but less interest paid.
- The length can differ by lender, sometimes 12 months to 72 months. (avoid more than 48 months)
Is an 84-Month Auto Loan Worth It?
Knowing that longer durations will cost more in the long run, is important. Many financial experts agree that 72 or even 84 months is not ideal and will cost almost double compared to a 48-month load.
MarketWatch covered this topic and said you should avoid an 84-month auto loan.
How Your Down Payment Impacts Financing
In addition to financing terms and interest rates, you must include other factors like your down payment and potential trade-in.
These will significantly impact your financing and the total amount you will be paying for the life of the loan. A bigger downpayment can save you money in the long run, even though you will be front-loading the payments initially.
Let's cover the importance of your downpayment.
A down payment reduces the loan amount and interest rate and shows lenders you're financially stable and capable. Commonly, the higher the down payment, the lower the interest rate. Ideally, it would be best if you aimed to pay for your vehicle in full or as quickly as possible.
ASIDE NOTE: However, if you are considering leasing, you want to reduce your downpayment to as low as possible. This is because you will never see that money again. It is not a security deposit, and it's going toward your overall lease terms.
It's important to note that you need more money for the down payment to avoid paying more. It's good practice to save up for your down payment.
There will always be an opportunity to buy a new vehicle. Don't have FOMO and rush into a financial obligation because you are thrilled to have a new ride! Always.
Your Credit Score and Its Impact
I have covered the interest rates currently available. However, your FICO or credit score determines which APR you qualify for.
It would help if you had a basic idea of where you might stand. Your credit score will decrease if you carry a lot of credit card debt.
Your perfect credit score is over 800, so you should try and get it as high as possible. A good credit score is around 780 and over, but financial institutions can determine where you land.
Credit Score Range
The Credit Score is a range of numbers that shows a person's creditworthiness. It affects their ability to get loans, mortgages, and credit cards. (2023 Rates)
Credit Score Range | Tier | New Car APR | Used Car APR |
|---|---|---|---|
800 - 850 | Excellent | 4.75% | 5.9% |
740 - 799 | Very Good | 4.75% | 6.2% |
670 - 739 | Good | 6% | 8% |
580 - 699 | Fair | 8% | 12% |
300 - 579 | Poor | 11% | 17% |
Below 300 | Subprime | 13% | 20% |
Impact of Credit Score on Loan Approval
A good rule of thumb is to Maintain good credit. This is a requirement for any loan approval. All lenders will use your credit scores to judge your money management skills and ability to repay. A high score means more chances of getting approved, while a low one can lead to rejection or increased rate terms.
You can improve your credit score in a few months by paying down your debt, reducing your debt, and paying on time without any missed payments.
Neglecting your credit score will result in rejected loan approvals or higher interest rates.
Check your credit report often and take action today to improve it if needed.
Overview of Loan Approval Process
You need to go through a loan approval process to obtain approval for a car loan.
Required Documents
For the loan approval process, certain documents must be provided. Here's what you'll need:
- Proof of income: Recent pay stubs or tax returns to prove your income.
- Identification: A valid govt-issued ID such as a driver's license or passport.
- Employment verification: Contact info for your employer and proof of employment.
- Credit history: A credit report with your credit score and payment history.
This list is just a brief overview, but each lender may need extra documents. Be sure to contact them first to review all the required documents.
Once the lender has all of your information, they can get back to you with what you qualify for and the total amount.
Importance of Repaying a Car Loan
An auto loan is a serious financial obligation. That said, you must stay on top of your monthly payments.
Missed or late payments will impact your credit score negatively, and if you totally miss your payments, you put your vehicle at risk of repossession. Typically, it takes 90 days since your last missed monthly payment for repossession to take place.
However, you will be ruining your credit score and causing damage to future financial loans and credit worthiness.
Consequences of Late Payments or Defaulting
Defaulting on an auto loan is a huge burden. It could lead to wage garnishments, legal action, and negative impacts on your credit score and finances. The lender could also sell your car at auction, usually for much less than you owe, leaving you with a bigger debt.
You are 100% responsible for your vehicle's debt.
In case you are facing financial hardship, communicate with your lender early. Often, they will try to work with you through creative solutions like refinancing and temporary deferment to help avoid repossession.
Don't ignore your financial issues. Trust me, and it's better to face them head-on. You are not the only one who has gone through this.
Final Thoughts: Automotive Financing
Financing a vehicle is relatively easy. There are many avenues to explore for financing.
Take into account your FICO score or credit score. This will help set the bar on the interest rates that you qualify for.
Consider your budget, monthly expense, and how long you plan to keep the vehicle.
Do not rush this process. You should compare multiple lenders and know what's available. This will allow you to choose the one that fits your lifestyle and financial goals.
Frequently Asked Questions
Q: What does financing a car mean?
A: Financing a car means that instead of paying the full purchase price upfront, you borrow money from a lender to pay for the car and make monthly payments with interest until the loan is paid off.
Q: How does the financing process work?
A: First, you apply for a car loan with a lender. The lender will review your credit score, income, and other financial information to determine if they will approve you for a loan and at what interest rate. If approved, you will receive the loan amount and use that money to purchase the car. You will then make monthly payments to the lender until the loan is paid off.
Q: What is the difference between a secured and an unsecured car loan?
A: A secured car loan is when the lender requires collateral if the borrower defaults on the loan, such as the car being purchased. An unsecured car loan is when the borrower has no collateral, and the interest rate may be higher.
Q: How long can a car loan term be?
A: Car loan terms can range from 12 to 84 months (7 years). The longer the loan term, the lower the monthly payments, but the more interest you will pay over time.
Q: Can I pay off my car loan early?
A: Yes, paying off your car loan early is possible. However, some lenders may charge a prepayment penalty for doing so. Be sure to check with your lender to see if there are any penalties before paying off your loan early.
Q: What happens if I can't make my car loan payments?
A: If you cannot make your car loan payments, your lender can repossess the car to recover their losses. This can negatively impact your credit score and make it harder to borrow money in the future.