Owning a car is more than just a convenience for many Americans; it’s a financial necessity. In large parts of the country, people rely on their cars to get to work and earn income. About 76 percent of Americans drove alone to work in 2019, according to Census data.
If you need your vehicle to earn income, you should have a budget for car maintenance costs on your current vehicle as well as a savings account dedicated to purchasing your next vehicle.
However, if your old car broke down unexpectedly, you could be facing a car purchase without any cash in your bank account.
Nearly two thirds of Americans report that they have been living from paycheck to paycheck since the pandemic hit in 2020. With little to no money in savings, a large share of Americans are financially unprepared for a large purchase like a car. And even if you live in a city where you have access to public transportation, it may not be the best option for commuting during a public health crisis.
If you need to buy a car right away, you might need to borrow money. Read on to explore your financing options and find out how to keep your costs low.
Best Car Financing Options
Cash
If you can save up enough to purchase your next vehicle outright, you could potentially save thousands on interest charges. Evaluate your budget while your current vehicle is still in good condition, so you can prepare for the inevitability that you’ll need a new car. You may want to set up a separate savings account for your car purchase, so that you won’t be tempted to tap the account for other reasons.
Auto Loan
An auto loan is a secured loan used to finance the purchase of a new or used vehicle. Since the vehicle you buy serves as collateral, you’ll risk repossession if you default on the loan. However, auto loans tend to carry lower interest rates than unsecured loans. The national average interest rate for a 60-month new car loan in Q4 of 2020 was 4.8 percent, according to the Federal Reserve. You can get an auto loan through a bank, credit union, online lender, or dealership.
Personal Loan
If you’re risk-averse, a personal loan might fit the bill. Personal loans are unsecured, so you won’t risk losing your car if you default. However, you should be aware that the average interest rate on a 24-month personal loan was 9.65 percent in Q4 of 2020, which is more than double the rate you’d get with a secured auto loan. Some lenders offer lower rates than that, but you’ll need excellent credit to qualify. If you’re making a large downpayment and just need a small loan to cover the difference, a personal loan might be a good option, since there are often minimum borrowing amounts on auto loans.
Dealership Financing
Some dealerships work with lenders to offer financing to their customers, while others use in-house financing. “Buy here, pay here” dealerships should generally be avoided unless you have no other options. These dealerships focus on offering in-house loans at high interest rates to customers with poor credit.
Dealerships that work with lenders can sometimes charge a higher interest rate than what the lender provides and keep the difference in exchange for getting the financing for you. That’s why it’s important to shop for loans before you visit the dealership.
The most attractive dealership financing options are typically only available on new cars for creditworthy customers. If you’re purchasing a new car and the dealership can offer a zero percent introductory APR, this might be your cheapest option for borrowing. Otherwise, you’ll likely get a better deal from a bank or credit union.
Steps to Take Before Applying for a Car Loan
Check Your Credit
Since your credit score will affect your interest rate, you’ll need to know what’s on your credit report before you decide how much car you can afford. You’re entitled to a free copy of your credit report at AnnualCreditReport.com. Look for errors such as old or incorrect debts and dispute any inaccuracies. You might also take steps to improve your credit if you can wait a few months before applying for an auto loan. You might work on paying off debt or ask for a higher credit limit, for example.
Prequalify with Several Lenders
Once you have an idea of your credit score, look for lenders that specialize in offering auto loans to your credit bracket. You might try banks, credit unions, or online lenders. You can also use a loan comparison site to compare rates across multiple lenders at once. Prequalifying won’t hurt your credit, since it only requires a soft credit check. However, keep in mind that the rate you get will only be an estimate.
Find a Car You Can Afford
Once you have an estimated APR, you can use the Edmunds Car Affordability Calculator to determine how much car you can afford. Start by entering your target monthly payment and preferred loan term, which should be 60 months or less. Then enter the lowest APR you were able to prequalify for and supply your trade-in and downpayment information. The calculator will return a sticker price range you can use to shop for your next vehicle.
Next, decide the features that are important to you and begin shopping for a car. While you may be tempted to buy a brand new car, you should be aware that new cars depreciate an average of 11 percent the minute you drive them off the lot. And after five years, your new car will be worth just 37 percent of what you initially paid for it. For this reason, used cars are almost always a better value. However, interest rates on used cars are generally higher, so do the math when comparing your options.
Save Up Some Cash
The more money you can put down upfront, the less you’ll pay in interest over time. If your car purchase isn’t urgent, take the time to trim your budget and stash away some extra cash. You might also consider asking friends or family for help with your downpayment.
Look into Insurance
Lenders require that you purchase full coverage auto insurance, so you should understand these costs before applying for a loan. You might want to grab insurance quotes for a few of the cars you are considering and compare costs. There are quote comparison websites you can use to make this process easier.
If you’re buying a new car, you’ll want to purchase Guaranteed Auto Protection (GAP) insurance. This covers the difference between your insurance payout and your remaining loan balance. For example, let’s say you purchase a $30,000 new car with a loan and total it the same day. Your car would only be worth about $26,700 due to depreciation, which is what your insurance company would give you, but you’d still owe $30,000 to your lender. GAP insurance would help cover the other $3,300 you owe on the car.
Apply for Loans During a 14-Day Period
When you have your car picked out, you can apply for loans. A formal loan application will require a hard credit check, but if you do all your shopping within a two-week period, you’ll minimize the hit to your credit score. You may want to apply at a bank, credit union, or online lender before assessing what rates the dealership can provide.
How to Reduce the Cost of Borrowing
Compare Rates Across Lenders
Every lender will weigh your credit information differently, so it’s important to prequalify with several different lenders before you apply for a loan. You can either use a loan comparison site to get rates from multiple lenders in one place, or you can prequalify at individual lenders’ websites.
Put 20% Down
If you can, make a sizable downpayment on your new or used car. This will reduce your monthly payment and the amount of interest you pay over time. For example, if you made a $5,000 down payment on a $25,000 car with a 10 percent interest rate, you’d save $1,375 in interest when compared to financing the total sticker price.
Keep the Term Short
Getting an auto loan with a term longer than five years will reduce your monthly payment, but it’s generally not recommended. That’s because the added interest can be costly, especially if you don’t have perfect credit. In fact, when you finance a vehicle with a bad credit auto loan, you could end up paying double the sticker price of the car. Keep the term as short as possible to avoid unnecessary interest charges. Just make sure the monthly payment is also affordable.
If You Have Bad Credit, Get a Co-Signer
Bad credit can have an outsized impact on the cost of financing a vehicle. If you’re having trouble getting approved for a traditional auto loan or you’re finding that the interest rate you qualify for makes it difficult for you to afford a car, enlist the help of a creditworthy friend or family member as a co-signer. Here’s how it works:
- The lender evaluates the co-signer’s credit information and determines a rate based on their creditworthiness, which applies to your loan
- The co-signer becomes financially responsible for repayment should you default
- If you miss a payment, it will appear on both your co-signer’s credit report and your own
Since your inability to pay would hurt your co-signer financially, you should make sure you can afford your monthly payments before asking someone to co-sign.
When and How to Refinance
Refinancing replaces your current auto loan with a new one in order to achieve a lower interest rate or more affordable monthly payment. It can be a good idea to refinance if:
- Your credit score has improved or interest rates have gone down since you last applied for a loan
- You don’t owe more than your car is worth
- There’s no prepayment penalty on your existing car loan
- You got stuck with a high interest rate because you financed through the dealership
- You can no longer afford your monthly payment
To determine if refinancing is a good idea, do the math to make sure you’ll be saving money in the long run, or at least lowering your monthly payment. If you’re able to get a lower interest rate, refinancing can save you a decent chunk of change.
The Bottom Line
The best way to pay for a car is with cash, but if that’s not an option for you, you should do your due diligence to find a financing option that won’t cost you a fortune. Compare APRs and terms across lenders, evaluate the interest rate and insurance cost difference between new and used cars, and don’t forget to leave yourself with enough cash to pay taxes and fees. If you have bad credit, avoid dealerships with in-house financing and consider a co-signer instead. You should also make every attempt to secure a monthly payment that leaves you with room to save for your next car, so you’ll be on better financial footing when that time comes.
The information contained herein is provided for free and is to be used for educational and informational purposes only. Consult a financial professional for specific help with your situation.