By any measure, transportation costs take up a significant portion of the household budget. For most households, car ownership is a necessity rather than a luxury especially in areas where public transportation is unreliable and even non-existent. In 2014, transportation expenses accounted for 17 percent of total household budgets according to reports from the Bureau of Labor and Statistics. Maintenance includes the cost of gas and motor oil, auto insurance and other incidentals.
A report prepared by NerdWallet, Inc. from data collated by the U.S. Census Bureau and the New York Federal Reserve indicated that the auto loan balance averaged $27,141 for households carrying this type of debt. In the U.S., the total value of car loans in 2015 reached $1.06 trillion. These figures confirm that car ownership and auto loans are part of the American way of life, and it is to your benefit as a consumer to develop enough savvy to know how to finance a car.
Before you Buy
Given the glut of information available on the Internet, there is no valid excuse to forego the research before scheduling showroom visits. Buying a car is described as one of the most stressful experiences for grownups because you are acquiring a big-ticket item. Car Features, prices and loan terms may vary from one dealership to the next, making it difficult for unprepared buyers to handle the crush of information that will is bound to make a major dent in your budget. Manage the car-buying process with less stress and more positive results by preparing judiciously for your encounter with car sales representatives who are experts on the products and persuasive strategies as well.
1. Get your finances and financial records in a row.
This part of the pre-buying phase cannot be emphasized enough. Purchasing any kind of vehicle is a major financial commitment whether you intend to pay cash, apply for financing or a combination of cash and loans. To determine how much you can afford, evaluate your financial situation.
Following is a sample expense table that you can use to compare how your finances will be affected by a car purchase.
|With Car Purchase|
|Monthly Income(net of all deductions)|
|Housing (mortgage or rent amount)|
|Utilities and Services|
|Insurance Premiums (car/home/life policies)|
|Student Loan Payments|
|Credit Card Payments|
|Total Income – Total Expenses|
|This is the maximum amount you can afford to allocate for vehicle costs, including gas and other expenses.|
|A positive balance means that you can afford your planned car purchase while a negative balance indicates that you will need to reassess your decision to buy a car.|
Many factors come into play when assessing the true costs of a new car purchase. The new car reference is used loosely here to refer to any vehicle for sale including pre-owned vehicles. You can alter the car loan amount and transportation costs using realistic estimates that are based on manufacturer and dealer-provided information on gas mileage, maintenance costs and insurance premiums. These values vary depending on:
- Make and model of the vehicle
- Age of the car if you are considering a pre-owned vehicle
- Features and extras that come with the car
Bonus Tip: Buying a car is an emotional process where personal tastes and practical issues clash. List the reasons for considering the acquisition, and be as specific as possible. For instance, if you want a car with enough trunk space for car seats, strollers and toys, consider how long you will actually need this type of car.
2. Obtain your free credit report.
If you intend to apply for financing, make sure you know what is in your credit report. Creditors refer to one or all three of these reports to assess your creditworthiness. The credit-reporting bureaus may have different versions of your history because their information sources vary. The reports will include the following information:
• Identifying information including your names, aliases, name changes and name variations are included. Pay attention to these details because discrepancies may arise from erroneously merged accounts.
• Your social security number is unique, and variations should be noted and corrected with the credit bureau immediately even if everything else on the report seems accurate.
• All addresses reported to the credit bureau through your various credit accounts will be part of the file. Consider it a red flag if you find any unfamiliar addresses in any of your reports.
• Open accounts including type of account, age, credit limit, payment history, most current outstanding balance and most recent payment.
• Closed accounts and specific collection actions taken may be included as creditor comments.
• Information from public records, including any records of foreclosure, bankruptcy filings, collections and other derogatory marks should be verified for accuracy. If the information is correct, there isn’t much you can do except to keep your credit record clean by making timely payments. Derogatory reports will be dropped from your record in seven or 10 years, depending on the type of action. Should your report include errors and inaccuracies, prepare to dispute the information using the steps outlined below.
• Your credit score should be part of the reports pulled by financing companies. The score may be different for each report.
These are the three nationwide credit-reporting bureaus and their contact information.
- Equifax Credit Information Services: 1-800-685-1111
- TransUnion Corporation: 1-800-916-8800
- Experian: 1-888-397-3742
Bonus Tip: You are entitled to a free copy of your reports from each credit-reporting bureau every 12-month period. Access your credit reports through one of these options:
- online at www.annualcreditreport.com
- by phone at 1-877-322-8228
- by completing the Annual Credit Report Request form that should be mailed to Annual Credit Report Request Service, P.O. Box 105281, Atlanta, GA 30348-5281.
In addition, when a credit application is turned down, you are entitled to a free copy of your report from the credit-reporting bureau used by your would-be lender.
3. Correct errors and inaccuracies in the reports.
The reporting agency and the entity that provided inaccurate, erroneous and incomplete information about you are responsible for correcting the information when requested and adequate proof is provided. This is part of consumer rights outlined under the provisions of the Fair Credit Reporting Act.
Part One: Contact the credit-reporting company.
- Contact the credit-reporting agency in writing. State the nature of your dispute and present each item and relevant documentation separately. Keep a copy of all communications including proof of mailing and return receipts to prove that the company should have your dispute on file.
- By law, the credit reporting company should review the disputed items within 30 days. A copy of your file will be forwarded by the credit bureaus to the entity providing the information so that they can investigate the dispute from their end.
- If your proof supports your request for correction, it is the responsibility of the provider to inform all three credit-reporting agencies so that your reports can be updated.
- You will be informed in writing when the results of the investigation are completed and corrections are made on your report. You may be entitled to a free copy of each corrected report.
- You can request that the credit-reporting company provide corrected copies of your report to any entity that received it in the last six months. If the credit report was accessed for employment purposes, you can request submission of an updated report to employers that accessed your records within the last two years.
Part Two: Contact the company that reported incorrect information.
- Contact the entity that provided incorrect information in writing. Follow the same procedures as listed above.
- If the entity continues to report the information to the credit bureaus, it must advise the credit bureau of the dispute.
- If you have sufficient proof, the entity must correct or delete the disputed information by advising the credit-reporting agencies of their findings.
Bonus Tip: The right time to review your credit report is not when you are already seating in front of the car dealership’s finance officer. Review your credit report regularly, and make sure you know what is in your report. Initiate dispute resolution quickly to flag incorrect information. Errors in your credit report affect your credit score, which can cost you real money when financing your car purchase.
Exploring your Auto Financing Options
You know what type of car you want, and you have a fair idea of your ability to obtain financing for this purchase. The next step is to put pedal to the metal to get you closer to car ownership by securing auto financing. Having your loan approval in hand is an ace up your sleeve when it comes to negotiating the drive-away price of your vehicle.
Car Loans from Direct Lenders
When plotting out how to finance a car, you should always start with the banks, credit unions and finance companies that you have established ties with through existing or past accounts. Dealing with your own bank may get you preferential treatment and favorable rates because of your history and the existence of active accounts. However, you should also go to other banks and financing sources to request pre-approval for your auto loan. This way, you can compare rates and loan terms from different sources before choosing a loan provider. Lenders establish their own standards, so it is possible to get better terms from one source even while these financing companies base their decision on the same credit report.
Typically, when you apply for auto financing, you will know your loan value, credit terms and finance charges upon approval and before you select a specific vehicle. Knowing these terms could help steer your car-buying decisions toward more practical features rather than flashy accessories, or the other way around if you prefer flash to function. When you become aware of how much you can afford to pay for a car, it helps to guide your choices as you shop so that you won't end up overspending and over-burdened with car payments.
The car-buying process is complicated because you are being asked to make several decisions all at once. By securing your funds sources prior to negotiating car prices, you will ease the pressure on yourself. It becomes easier to track the numbers as the helpful sales representative dazzles you with costs and extras that are bundled with the car price and the auto financing arrangements.
Dealership financing is one of the most common ways to finance your car. The dealerships promote this option because it is in their best interest to provide as many in-house services to customers. It is convenient for customers to have a one-stop source for their car-buying and car-financing needs. Customers can be connected to lenders while they are in the dealership, making it possible to finalize the buying process seamlessly and without delay.
The dealerships do not actually provide the financing themselves. They partner with banks and auto finance companies to provide a range of financing options suitable to customers of varying credit risks. This means that the dealerships have access to car financing programs for high-risk borrowers who may have some difficulty obtaining traditional loans from lenders. Borrowers with excellent credit scores and financial history will not find it difficult to obtain a car loan at favorable terms from any lender.
Additionally, dealerships offer car-buying incentive programs throughout the year. These programs are usually manufacturer-sponsored discounts, rebates or low-rate strategies to entice buyers. The programs may be limited to certain models, or they may specify loan terms such as higher down payment, payment terms within 36 or 48 months and a credit score in the top range.
Bonus Tip: You have to do the research to find the best car loan program. Comparison shopping is key to finding a loan with terms that you can live with comfortably. This is important because the average loan term for car financing is 60 months. In 2014, 62 percent of all auto loans were written for 5-year repayment terms. However, about 20 percent of car loans carried a 73 to 84-month repayment clause, which can be very costly for consumers.
Understanding the True Costs of Car Financing
It’s not enough to look at prevailing interest rates for auto loans when you are planning to finance a car. These rates are tracked on a regional and national basis, but the applicable rate for each applicant may be significantly above the median. Factors that may affect your interest rate include:
- Your credit score – Based on information found on your credit reports, this three-digit number is generated using a mathematical algorithm. Each credit bureau applies a formula to data provided to them to come up with your FICO score. You will have one score each from TransUnion, Equifax and Experian. The scores vary, but the exact weight placed on different credit factors are not public knowledge. Lenders’ standards differ when it comes to what constitutes a good credit score.
- Dealer financing may be available for borrowers with low credit scores. Subprime borrowers may be offered loans at interest rates that are much higher than those quoted to buyers with excellent credit scores.
- Loan repayment terms – Longer loan terms reduce the monthly payment, but you will end up paying more interest at the end of the contract.
- Tax on the vehicle purchase – Taxes are charged upfront as you affirm the sale. However, the amount of tax is added to the total loan value. Taxes won’t increase your interest rate, but they will increase the amount of principal that serves as basis for interest payment calculations.
Calculating Interest Payments
The annual percentage rate or APR is the cost of the loan calculated on a yearly basis. This rate is based on several factors, most of which are contained in your credit report. This rate may be negotiable depending on your credit history, amount of down payment and proof of other assets and income.
Most car loans apply simple interest, which means that interest charges for the period are calculated using the remaining balance on the principal. Simple interest will save you money because it is not compounded. However, interest charges are amortized over the loan repayment period so that you can expect to pay more interest charges at the beginning of the loan term because the principal balance is higher. Paying down the outstanding balance reduces interest charges because the basis of interest calculation is lower. If you want to reduce the amount of interest charges, consider making extra payments when you can to reduce the principal amount much quicker. For this reason, make sure that your car loan agreement does not include a pre-payment penalty.
When negotiating a car purchase, the emphasis is on the drive-away price while very little attention is given to the true costs of a car ownership after finance charges are factored in.
Cost of Extended Loan Terms
The following table illustrates how much extra you will be paying with longer loan periods.
|Loan Amount: 20,000|
|Interest Rate: 4.7 %|
|Total amount paid at payoff|
|Total interest charges paid|
The table shows that interest charges on a $20,000 car loan would amount to as much as $1,977.90 on a 48-month car loan at 4.7 percent interest. It is clear that increasing the loan repayment period would reduce monthly payments, making it possible to afford a bigger loan, but the extended term would cost you because you will be paying more interest charges over the life of the loan.
Cost of Higher Interest Rates
Most consumers understand that higher interest rates on an auto loan will be reflected on the monthly payment and the total cost of the car after it is paid off under the original loan terms.
|Loan Amount: 20,000|
|Best rate/Low-risk Borrower|
|Monthly payments for 48 months|
This table illustrates two points:
- Qualifying for lower interest rates, which is customarily given to low-risk borrowers with strong credit scores, lowers your monthly car payments.
- Lower interest rates will result in significant savings on interest charges, so you end up shelling out less money for a car purchased with an auto loan.
Bonus Tips: Whether you are financing a car loan through the dealership or a direct lender, make sure to ask questions before signing the papers. If anything sounds vague or too good to be true, ask for clarifications before you sign. Do not be afraid to walk away from loan negotiations if you feel that you are not being offered a fair deal. Consider online banks and lenders as alternative car loan sources, but make sure to verify their reputation before you submit your personal information.
If you are financing your car through the dealership, verify that the loan application is approved and final before you leave with your new car. If you are told that loan approval is still pending, hold off on signing the sales contract. Keep the keys to your own vehicle until financing is fully approved. Make sure that you understand all the loan terms before you sign and turn over your trade-in vehicle if this is part of the purchase and financing deal.
Optimizing the Value of Your Trade-in Vehicle
There are many reasons for upgrading your existing vehicle. Problems with mechanical parts and technological glitches could make the car unsafe to drive. If you do not have the knowledge and specialized tools to do any repair work, you would most likely consider trading up for a problem-free vehicle. Growing families may need more space and the newest child safety features in motor vehicles. These are all sensible reasons for changing vehicles, and your current vehicle can be used as a trade-in to reduce the amount of down payment required to buy a new car. As such, you should make every effort to maximize the value of your trade-in vehicle.
Five factors affect trade-in value:
- Model Year: Newer models command higher resale prices. Assuming your current car is one of the popular models, expect a favorable valuation from the dealer.
- Make and model: If your car is one of the models that retain their value or remains desirable past its launch year, expect a decent offer on it.
- Condition: Make sure that the car is cleaned and detailed on both interior and exterior.
- Mileage: High mileage reduces the trade-in value even when the car is in good condition.
- Popularity: Some cars become trendy items as result of social media or pop culture influence.
How to Make the Most of your Trade-in
Your goal when financing a car is to keep the loan amount as low as you possibly can by applying various strategies.
- Negotiate a lower sale price.
- Make a substantial down payment.
- Get the best offer for your trade-in.
When it comes to trade-ins, information is power at the negotiating table. Do your research: Find the resale value of your car by using free tools available on the Internet. You can try to sell your car on your own to generate cash for your down payment, but the convenient option is to sell to the dealer, which is what many buyers do. According to Edmunds.com, 48 percent of vehicle purchase transactions in 2013 involved a trade-in.
To negotiate effectively, understand that the estimated value on Kelley Blue Book or Autotrader will always be higher than the dealer's offer. Look up the appraisal value for your car, and use this information as a guide when you negotiate for a favorable appraisal value of your trade-in vehicle.
If you have a balance on your existing car loan, this amount can be folded into your new loan, increasing the loan amount, and consequently, your monthly payments. The upside of this arrangement is that the favorable loan terms you negotiated will apply uniformly to the principal. This strategy comes with some financial risk to you since your car loan will essentially be higher than the value of your car.
Bonus Tip:When you go to a car dealership to finalize a car purchase, you will be involved in three distinct transactions:
- Negotiating the price of the new or used car
- Negotiating the terms of your car financing, assuming you opt to take advantage of dealer financing
- Negotiating the appraisal of your trade-in vehicle if you have one
Typically, the dealer will tackle all these transactions together, presenting you with a worksheet that includes all three values with emphasis on the final cost without future interest charges included. It is easy for anyone to become overwhelmed with the numbers, erroneously focusing on the final price as a figure that falls within your budget. The value of your trade-in may get lost in the shuffle; it may seem like the dealer is giving you concessions by discounting or eliminating some charges, but the worksheet may also be adjusting your trade-in value at the same time. Finance experts recommend separate negotiations as much as possible. Review each line item entry as changes are made during the negotiations.
Buying vs. Leasing
When you lease a car, you are paying for the right to use it for a defined length of time, which could be anywhere from 12 to 36 months. Mileage usage is capped at a certain level, and exceeding the mileage limit could mean hefty fees at the end of the lease term. When the lease ends, the vehicle must be returned in acceptable condition to the dealer. You may have the option of purchasing the car when the lease expires.
Monthly lease payments are typically lower than monthly amortizations for a financed car. The down payment is minimal for a leased vehicle, making it convenient for consumers to drive away in a new car, and the vehicle is always under warranty. Leasing ensures that you can replace your car every few years, but be aware that you may be subject to extra charges for going over the mileage limits and any damages to the vehicle. Be aware of the provisions of the Consumer Leasing Act, which requires the dealer to disclose important information prior to your signing of the lease.
Bonus Tip: If you intend to use the car for three years at most, leasing is a viable option. Additionally, if you anticipate that your total mileage in a year will not exceed 15,000 miles, leasing may be a better option than financing a car. Initial payment and monthly charges would be lower, but you will not have a trade-in asset when you update your car. Your credit report will also be used to determine if you can own a car under a lease agreement.
Choosing Between New or Used Cars
Making a choice between a fresh-from-the-assembly line vehicle and one that is certified pre-owned will impact your auto financing options.
- Interest rates for new car loans are typically higher than interest rates for used car loans
- The price of a brand-new vehicle will be substantially higher than a certified pre-owned car of the same make and model but from an earlier year. This means that your principal loan amount is potentially lower if you were to choose a used car.
- As first owner of a new car, you will be absorbing most of the depreciation because the car loses most of its value within the first three years. According to Kelly Blue Book’s cost of ownership calculator, a car loses about 20 to 30 percent of its original value in the first year. By the second year, the car would be valued at 60 to 70 percent of its original price. The rate of depreciation varies depending on the make and model as some brands hold their value better than others do. Depreciation is not usually a consideration if you intend to drive the car to the ground, but the trade-in value makes a hefty impact on your next car purchase.
Cost and financing considerations aside, there are obvious advantages to buying a new car. The vehicle will be under warranty for the first few years or few thousand miles. Warranty terms vary based on manufacturer guidelines and make and model of the car. Some car manufacturers offer free maintenance and basic services during the first few years of ownership. These free services may be enough to mitigate the higher price you will be paying for the car.
Practical Considerations: How to Finance a Car
Buying a car and getting the best deal for your budget requires careful planning. There are two distinct parts to this process:
- Shopping for the best deals on car financing that offer the best rate and terms based on your credit worthiness
- Shopping for a vehicle that meets your needs with a price within your means
You can do much of the research on cars and auto loans online. Various calculators are available to help you figure out monthly payments and total costs of finance charges over the life of the loan. Interactive resources allow car shoppers to explore alternative financing sources to make sure that you can take advantage of the best offers available to you.
Prepare to negotiate with lenders, dealers or both. Carefully review any paperwork requiring your signature before you sign it, and don't hesitate to ask for clarifications even if it means delaying the processing of your car loan or sales transaction. Make sure that you have a copy of all the paperwork before you leave the lender's office or the dealership. Clarify that the loan agreement or sales transaction is completed and fully approved before you drive off with your new car.
- Federal Trade Commission, Consumer Information: Understanding Vehicle Financing
- How to Finance an Auto Purchase, WSJ.com
- Kelly Blue Book, Six Steps to Financing
- Erin L. Issa, 2015 American Household Credit StudyCard Debt Study, NerdWallet.com
- Russ Heaps, 4 Questions to Help you Decide on a New or Used Car, AutoTrader.com April 2012
- Federal Trade Commission, Consumer Information: Disputing Errors on Credit Reports
- Ronald Montoya, How Long Should My Car Loan Be?, Edmunds.com, March 6 2015
- Current Auto Loan Interest Rates, BankRate.com
- Margarette Burnett, 4 Steps to Boost Car Trade In Value, BankRate.com
- Russ Heaps, 4 Questions to Help you Decide on a New or Used Car, AutoTrader.com