December 27, 2017

How to Finance a New Car: What You Need to Know

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How does a new car loan work and is financing a good idea? Learn the best ways to finance an auto purchase with a low APR.

© Jaguar MENA (CC BY 2.0) via Flickr

Shopping for new car financing should happen before you shop for a car. Sound backward? It's not. It helps you stay on budget. It also helps you get the best deal.

Certain buyers benefit from getting financing right from the dealer. Others do better by shopping online or with a local bank.

Keep reading to find out where you'll find the best place for new car financing.

Be a Smart Borrower

No matter where you get your financing, you want to be a smart borrower. For many people, buying a car is unavoidable. They need it to get from Point A to Point B, but they can't afford to pay cash. Just about 15% of buyers pay cash for a new car. If you aren't among the elite 15%, you'll need financing. Don't make a rash decision, though.

You don't have to borrow the amount a lender approves for you. If you have excellent credit and decent income, you may hear large numbers thrown at you.

Before you have BMW and Mercedes cars dancing in your head, think realistically. What can you afford? Look at your monthly budget and come up with a realistic number. Then plug that number into a car affordability calculator. Working backwards, you'll know how much car you can afford.

The affordability calculator takes into account your trade-in value and/or your down payment. Play with the numbers to see what you can afford.

The Right Down Payment

How much money you put down on the car determines your loan payment. The more you put down, the less you borrow. You'll pay less each month and less interest over the life of the loan.

The magic down payment number is 20%.

On a $30,000 car, you'd need $6,000. It doesn't have to be in cash. If you have a trade-in worth $6,000, you'd have 20% down. The higher the down payment, the more you fight the initial depreciation. Without a down payment, you could be upside down on your car loan in the first year.

Next, you'll choose the term. Ideally, you want a 3-year term. You'll pay the least amount of interest. If you can't afford the 3-year term, consider your options.

Choosing the Right Term

A $300 car payment over 36 months means a much cheaper car than a $300 car payment over 72 months. Even with a higher interest rate, a 72-month loan can get you an $8,000 higher purchase price than a 36-month loan.

Choosing a longer term often means a lower payment. It may sound enticing, but look at the big picture. Take a $20,000 loan at 4.5%:

  • 36 months: Payment of $594 and total interest of $1,400
  • 72 months: Payment of $317 and total interest of $2,858

In the end, the 72-month loan costs you $1,458 more, assuming the same interest rate. Generally, lenders charge higher rates for longer-term loans. This would increase the total cost of the car even more.

If you have one goal when buying a new car, it should be to pay as little interest as possible. Cars depreciate as much as 30% the first year you own them. Over the next 3 years, you'll see an estimated drop in value of around 20%. The next largest drop occurs around the 5th year. If you stretch your loan out over 6 years, you'll likely owe more than the car's value for most of the life of the loan.

Being upside down is a bad move. If you can't sell the car for the amount of the loan, you'll have a deficit. You'll have to make up that deficit in order to secure the car's title. Otherwise, you're stuck with the car until you payoff the loan.

Once you work out the details, it's time to shop for a loan.

Great Credit Consumers

If you know your credit score is above 750, go directly to the car dealer. If the dealer and/or manufacturer has a 0% APR deal going on, this is your best bet.

Taking a loan with a 0% APR works just like paying cash. You don't pay any more money for the loan than someone who put down the entire amount in cash. Watch out though, the loan terms are generally shorter. You'll have higher payments - but without any interest - so it's a deal.

Where you should be careful, though, is the price of the car. Generally, the dealers themselves lend you the money for a 0% loan. They figure either they give you the 0% or they lose your business. But they are less likely to give you a lower price on the car. They know they aren't making any money on interest.

If you don't qualify for the 0% APR, don't get financing from the dealer. They like to reel customers in with the 0% advertisement. When they have a customer who doesn't qualify, they throw other options at them. These options may not work in your favor.

Read on to see where you should go.

Average Credit Consumers

If you aren't among the top 10% of car buyers with a 750+ credit score, you'll want to do a little legwork yourself. Even though the dealer works like a broker and can offer you several car loan quotes, shop around.

While it's convenient to get financing right from the dealer on the spot, it comes at a price. The rate the dealer quotes you generally isn't the rate the bank offers. The dealer wants to make money on the deal too. They can mark the rate up as much as 2.5%.

Let's look at how this could affect you. On a $30,000 car loan for 48 months, let's say the bank offered 4%. This means a $677 payment and $2,513 in total interest.

If the dealer added 2% to the rate, charging you 6%, you'd pay $704 per month and $3,818 in total interest.

Rather than letting the dealer make the money, do the work yourself. Call local banks and credit unions. Try applying for car loans online too. Look closely at the rate, term, and fees for each loan. Choose the one that will cost you the least in the end, but has a payment you can afford.

Watch What You Finance

Closing a car deal means paying other fees. You'll hear many numbers thrown at you, but the most common fees include:

  • Sales tax
  • Registration fees
  • Document fees
  • Extended warranty costs
  • Aftermarket accessories

Don't finance these fees and/or extras. If you can't pay for the extras in cash, don't get them. Neither the fees nor the accessories help the value of your car. Before you know it, you could be upside down on your loan before you even walk out of the dealership.

Should You Get Gap Insurance?

Gap insurance covers the difference between your loan and car value if you are in an accident. If you total the car, but the insurance company values it lower than your loan, you have a deficit. Gap insurance can cover the deficit.

Most people don't need gap insurance, but get talked into it. With a 20% down payment and a 3- or 4-year term, your car's value shouldn't depreciate below the loan amount.

Gap insurance is an example of another fee you may add on and finance. Even if it's only another $600 or so, it adds to the interest you pay on the loan.

The Bottom Line

Financing a new car doesn't have to be a bad financial move. Keep your term short and your down payment high. You'll beat the car's depreciation and minimize the cost of the car.

Don't assume you can only secure financing from the dealer. Shop around and find the loan that saves you the most money in the end.

Disclaimer: Opinions expressed here are those of the author's alone. Please support CreditDonkey on our mission to help you make savvy financial decisions. Our free online service is made possible through financial relationships with some of the products and services mentioned on this site. We may receive compensation if you shop through links in our content.

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