Updated November 5, 2020

Best Way to Finance a Used Car

If you aren't careful, financing a used car could end up costing you more than the total cost of a new car. Used car loans often have higher interest rates and shorter terms.

Lending money on used collateral poses a higher risk for lenders. The uncertainty of the car's value and unpredictable condition puts lenders at risk.

This doesn't mean you can't finance a used car or that it has to be expensive. Finding your own financing can solve this problem.

Many car buyers think they have to use dealer financing. You don't. In fact, you probably shouldn't unless you've shopped around for your own deal first.

Not shopping around for a used car loan could cost you. You run the risk of high-interest rates, high down payment requirements, and shorter terms.

Keep reading to learn how to find the right loan for you.

Best way to finance a used car:

  1. Know your credit score and make sure your credit report is up-to-date.
  2. Work on improving your credit first if your score is below 650.
  3. Know what you can afford. Monthly car payments should not exceed 10% of your after-tax income.
  4. Shop around for the lowest financing rate at local banks and credit unions.
  5. Use that rate to negotiate with the dealership.

Know Your Credit Score

You must be an informed consumer when shopping for a car and car loan. Before you step foot on a car dealer's lot, pull your credit report. You are entitled to a copy of each of the three credit bureau's credit reports annually. Visit www.annualcreditreport.com for your copy of one or all three reports. These reports show your credit history.

Go over each report and look at the accuracy of what is reported. If there are any errors, report them right away. Write a letter to the agency reporting the error. Include proof of the error along with it. Even though the credit bureau must contact the company reporting the error, you should contact them as well. This will give you a better chance of getting the incorrect information fixed.

Any delinquent information on the credit report that is correct will remain. The best thing you can do is make sure everything is up-to-date. Don't apply for a used car loan with current late payments. Bring all accounts current first. Pay down any balances that you can as well. The less outstanding debt you have, the better your chances of approval.

Your free credit reports will not show a credit score, though. If you are concerned about your score because of delinquent accounts, you can secure free credit scores from Credit Sesame. This will give you a good idea of your credit score's range. If your score is below 650, work on fixing your credit before finding a car loan.

Know What You Can Afford

Having a figure in mind will help you stay on track when shopping for a car loan. Lenders use general standards when qualifying you for a loan. They will tell you the maximum loan amount you can receive. Realistically, though, can you afford it? That's what you must determine.

Look over your budget. How much room do you have for a car payment? Keeping your monthly payment at 10% of monthly net income is a good rule to follow. If you make $4,000 per month, your car payment shouldn't exceed $400. This leaves room for other transportation costs, such as gas, maintenance, and insurance. Ideally, your transportation costs shouldn't exceed 20% of your monthly take-home pay.

Once you know how much you can afford, use a car affordability calculator. This can help you determine how much car you can purchase. The only information you need is:

  • Monthly loan amount
  • Amount of down payment
  • Estimated value of a trade-in (if applicable)
  • Estimated interest rate
  • Desired term

After you arm yourself with this information, it's time to shop around.

Get Your Own Financing

Don't make the mistake of going straight to the dealer. It might seem convenient, but it may cost you a lot more than other options that may be available out there.

Start by shopping at local and online banks and credit unions. If you have a relationship with a bank already, contact them. They may have special deals for current customers, especially if you have a good history with them. You'll find a large range of rates and fees among lenders. Make sure you compare them closely to determine which one is right for you.

Don't assume the lower payment is the right option either. Look at the term. A shorter term means a slightly higher payment, but less interest. A longer term means a lower payment, but more interest. The longer you borrow the money, the longer you pay interest.

Choose the loan that fits your budget but doesn't cost excessive interest. Minimizing the loan term will usually give you the best option.

Once you choose a deal, get it in writing. When you go to the dealer, this will be a large part of your negotiation tools.

Negotiating a Deal

Once you have your financing, it's time to negotiate the price of the car. Keep in mind, the dealer will try to get you to take their financing. They'll even tell you they can offer you a better deal if you take their financing.

Car dealers make a lot of their profit off the financing deals. Car dealers receive bids from various banks for financing for their customers. It's similar to the process you would go through if you obtained your own bids from lenders. However, lenders allow the dealer to "mark-up" the rate. Today, the average mark-up is 2.5%. If a bank offers the dealer a 4% loan for your car purchase, the dealer may quote you 6.5%, pocketing the 2.5% difference.

When you walk in with your own financing, dealers have two options. They can take the cash deal or meet/beat the offer you already have. This gives you more negotiating power when buying the used car.

Avoid This Mistake: Don't walk into a dealer and tell them how much you can afford monthly. They can use that amount to their advantage. They'll meet the monthly payment, but stretch out your term. This allows them to charge a higher price or higher interest rate. You think you're getting a deal because the payment is what you can afford.

Don't lose your nerve when negotiating. Chances are, the sales manager will try to "sweeten the deal" by throwing in other incentives. He may even try throwing a lower interest rate at you. Don't take it at face value. Get the details in writing. Then compare the offer to what your bank provided. Make sure the term and fees are the same.

If the deal isn't the same, be ready to walk. Don't feel pressured to buy the car, no matter how much you want it. There are other cars out there and you aren't dependent on the dealer for financing.

Alternatives to Used Car Loan

Taking out a used car loan isn't the only way to pay for a used car. Of course, cash is always accepted, but only 46% of used car buyers pay cash. If you don't want a car loan, consider these options:

  • Home equity loan: If you have equity in your home and can access it, you may use it to buy a used car. Home equity loans usually offer lower interest rates than auto loans. You may also be able to write off a portion of the interest you pay on the loan on your taxes.

  • Personal loan: If you have a good relationship with your bank, you may secure an attractive rate on a personal loan. Banks don't usually ask how you'll use the funds. Make sure you compare the rates and fees closely, though. Personal loans are usually unsecured, which could mean higher rates.

  • Peer-to-Peer loans: If your credit isn't great and you don't like the offers you receive, try peer lending online. This is becoming more mainstream today as more investors pool their money for lending. The financing usually occurs quickly. The red tape is often minimal too, compared to a standard bank or credit union.

The Bottom Line

Buying a used car can save you thousands of dollars off the price of a new car. You don't take the depreciation hit new car buyers take. Losing 30% of your investment in one year is a big loss. Minimizing that loss by buying used can be a great choice. You just have to be choosy about your financing options.

Do your homework and make sure you are an attractive applicant. Maximize your credit score and increase your down payment for the best terms available today.

Write to Kim P at feedback@creditdonkey.com. Follow us on Twitter and Facebook for our latest posts.

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