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Auto Financing for Smart People: Tips for Saving on Your Car Loan

Earlier this week I wrote about mistakes we make when buying a car. One of those mistakes is overlooking the importance of the auto financing in the overall cost of your new car.

The example I gave is if you are buying a new Honda Civic, the difference between “sticker price” and the dealer’s invoice price (what the dealer paid for the car) is about $1,500. If you negotiate well, you could save $1,000 or more on the price of the car. If you then finance the car for four years at 6% with nothing down, you’ll pay over $2,000 in interest. Financing the car for three years at 4% with a $1,500 down payment, however, can save you over $1,000.

If you’re willing to negotiate the price of the car, you shouldn’t ignore the rates and terms of your financing. I made this mistake the first time I bought a car many years ago and vowed never to do it again. I posted some of this article based on my personal experience a couple years ago, and have vastly enhanced it for today. If you’re in the market for a new car—don’t wait until you’re in “the box” (what some dealers call the offices where you finish the paperwork) to think about your financing.

AUTO FINANCING TIPS

Cars aren’t investments. Quite the contracy, cars depreciate like crazy. For this reason alone, it’s not smart personal finance to pay interest on a loan to buy a car. What happens in many cases is the value of the car drops faster than you repay the loan leaving you upside down or underwater (when you owe more on the loan than the car is worth).

That said, many of us need cars to get to our jobs and don’t have the cash lying around to buy a reliable ride. So we get a car loan. That’s cool, but of course there’s a difference between using a car loan wisely and using it to buy a lot of car you can’t afford. I have the credit and income to go out and get a loan for a BMW M3. And I would love that car. But that doesn’t mean I should get it. What the dealerships will tell you can afford and what you should spend are two very different things.

So whenever you finance a car, you want to think about it not just from a monthly payment standpoint (how will this $350 payment affect my monthly expenses) but also from a total cost point of view. Here’s what I recommend: 

Understand Your Credit!

If there’s ever a time to check and understand your credit report and credit score, it’s before you get a car loan.

Here’s the deal: unlike mortgages or a credit card, you can usually get a car loan even if you have pretty bad credit—you’ll just pay (a lot) more. The reason? It’s relatively easy for the banks to repossess a car if you don’t pay.

But if you have shaky credit, you’re likely to be excited to get a loan at all, so you’re not going to want to ask if there’s a lower rate available. Dealers know this and they make a lot of money based on it. Free tools like Credit Sesame or Credit Karma can help you understand where your credit score falls and what kinds of interest rates you might qualify for. You can check the latest average auto loan rates at Bankrate as an up-to-date benchmark.

Shop Before You Go

If you have excellent credit and you know it, you can usually get the best financing rates right from the dealership, who serves as a broker for multiple lenders. With great credit you may qualify for incentive 0% APRs or other low financing rates. The key is to know your credit is good so they can’t try to tell you otherwise.

If your credit is only average (say less than 700), you can benefit getting some loan quotes before you hit the dealership. You can visit your bank or a local credit union and apply for an auto loan before you start car shopping or use an online loan broker like this one (an affiliate of this Website). Most of the time local banks and credit unions can offer borrowers with average credit the most competitive interest rates on both new and used car loans. Even better, you may be able to use the pre-arranged financing as a bargaining chip with the dealership’s finance and insurance (F&I) manager and score an even lower interest rate.

Keep The Term Short

Shorter loan terms come with lower interest rates but higher monthly payments. And that’s what you want.

It’s tempting to stretch out a loan over five or even six years to watch the monthly payment drop, but this means you’ll pay a lot more in interest and almost certainly be upside down on your car.

Put 20% Down

In addition to a short loan term, you can avoid a situation in which you owe more money than the car is worth by putting money down. This may seem like a no-brainer, but many dealerships don’t even require buyers with good credit to make any down payment at all!

Pay For Taxes, Fees and “Extras” With Cash

When you buy a car, there are always miscellaneous expenses like sales tax, registration fees, documentation fees and any extras you choose to purchase like extended warranties. Often, dealers are more than happy to roll some or all of these fees into your financing. Unfortunately, doing that just ensures you’ll be upside down on your car loan, at least for a while, since you’re increasing the amount of your loan but not the value of the car securing the loan.

OTHER CONSIDERATIONS

Gap Insurance

Gap insurance (guaranteed auto protection insurance) is something car dealers and lenders sell you to cover the “gap” between what an insurance company thinks your car is worth and what you owe on your car loan in the event you’re in an accident and the insurer declarres the car a total loss. (The insurer will only pay book value for the car, regardless of what you owe on the loan.) So if you crash your car and still owe $12,000 on your loan but the insurance company only covers the car for $10,000, you’re responsible for paying back the $2,000 (and you’re without a car).

People buy gap insurance based on fear because nobody wants to be in the position of owing a couple thousand on a totaled car. But if you structure your car loan correctly (put money down and stick to a three year term, you can feel confident that you won’t need gap insurance because your car shouldn’t be worth less than what you owe.)

Prices for gap insurance vary widely (from $30 or so a year to over $600 for the term of a car loan). The policies the dealers offer may be the most expensive, so if you feel like you need gap insurance, contact your auto insurance agent.

REFINANCING A CAR LOAN

So you didn’t see this article in time and got stuck with a really bad car loan. No big deal. If your credit is good and your car isn’t too old, you should be able to refinance your car loan just like you can refinance a house.

The best place to ask about car loan refinancing is a local credit union, but you can also get free quotes from online loan brokers like this one. Ask about any fees for applying or initiating the loan and avoid lenders who want to lower your monthly payment by extending the term of your loan. (With an auto loan refinance, you want to get a lower interest rate and pay down the loan over the same or a shorter term).

RECAP

Unless you’re looking at 0% or another really low APR, the best way to buy a car is with cash. If you have to get a car loan, be as pragmatic as possible. Know your credit score going in. If it’s less-than-perfect, shop for a loan before you go to the dealership and use these offers as leverage to get the lowest APR possible. Keep the terms as short as possible and put money down to avoid a loan in which your destined to become upside down. And remember to shop around and compare insurance quotes often once you have the car– putting in that extra effort really could save you hundreds over the lifetime of the car.

What about you? Have you learned lessons the hard way about the auto financing process you can share with others? Let us know in a comment!

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About David Weliver

David Weliver is the founding editor of Money Under 30. He's a cited authority on personal finance and the unique money issues we face during our first two decades as adults. He lives in Maine with his wife and two children.

Comments

  1. Excellent thoughts. We bought a car with a little less than 20% down, negotiated a fair price, and got 0% down, so at least we’re not paying interest on it.

  2. This is a great article, but I think it should also be mentioning leasing a car as an interesting alternative to financing a car on a personal loan. Car Leasing addresses partly the issue of car depreciation as it enables you not to own the asset (ie the car) which depreciates so much over the initial 2 years. It also makes it much easier to change car regularly as one grows older and has different needs.

  3. David Weliver says:

    Unfortunately, Simon, I couldn’t disagree with you more. Unless it’s for business purposes, leasing a car just makes bad financial sense: you pay out thousands over the two years of monthly payments but have nothing to show for it at the end (lease buy-out options are typically awful deals). New cars may depreciate, but at least when they’re paid off you still have transportation.

  4. We got approved for an auto loan from our credit union before we set foot in the dealership, and got a decent rate. When the dealer found out we were planning on financing with someone else, they beat the rate.

    Now, almost two years later, the credit union will beat the rate we got from the dealer, so we’re switching and will lower our monthly payment. I’ll put the difference aside and then have more than enough for insurance when that bill comes due every six months.

    The plan, once this car is paid off, is to keep “paying” the regular payment every month, into a dedicated savings account. Then, when the time comes around again for a new car, I’ll be able to pay cash, and won’t really have felt the pain of saving up the money.

  5. David I am inclined to agree with Simon about investigating a lease. Most people have a misconception about how the numbers wash out in the end. If you compare a lease with a bank finance, side-by-side, you may find it quite attractive. It takes an experienced F&I Manager to review the comparison and consider all the “what-if” factors. For example, the used vehicle market took quite a tumble last year, particularly the fuel guzzlers. Anyone leasing one of those vehicles that came off lease last year was thrilled that they didn’t have to take ownership of a vehicle that was worth thousands less than they would have owed had they financed…even if it was 0%.

  6. Cathy, thanks for the good comment. I agree that comparing different financing alternatives is quite difficult because it’s not just about the APR which is what people typically look at.

    David, I can understand why you can disagree with me, but I think the answer is that it really depends on one’s circumstances. I hope that you would agree that monthly payments on a lease are usually cheaper because you are only paying for the “use of the car” instead of the full asset. Also, you can get very interesting offers on leases because there is more margin in it for the dealer or finance company. If you combine these 2 factors, you may end up paying a relatively low monthly payment to drive a much better car that paying it on finance and you can then switch to an even better car when you get a pay rise 2 or 3 years later! I think this is particularly relevant for young couple who usually need to upgrade cars as the family grows.

  7. Good post, I have just purchased a new car by loan. I think it is much better to take a loan rather then purchasing the car on direct cash. Loans are better since you do not feel the load of repaying it as it has EMI system.

  8. Darryl Memering says:

    If I can finance a car at very little to zero percent I always do. “GAP” is a beautiful thing. If you pay a car in cash, esp a new one, and it is wrecked or stolen you are out anything that the insurance company deems over the cost. 150 dollars and small interest rate is worth it since I live in a town full of blue hairs that basicaly drive until they hit something. I know a couple people that have been stuck with 1500-3400 worth of car payment… and no car.

  9. Great information on this blog, David.
    I have another tip for car buying. Take a loan for 5 years, but do your personal amortization table to pay it off in 3 or less. This prevents a high monthly payment strapping you down if there are any unforeseen expenses.
    Also, many dealers give a larger discount on the price of the car if you agree to finance for a longer period.
    If you have to finance, and are disciplined, you can often end up paying less at the end of the loan.

    • Ultimately, I think buying a used car with cash is always the best alternative.

      If you must have a new car, then I think paying with cash will always get you a better deal than financing because you should be able to get the sale price of the car lower than you would if you were financing.

      If you must buy a new car and finance it, I think Joe, here has the right idea. Obviously, weigh the incentives first. Before I understood the beauty of buying a used car, my wife and I bought a new car on a loan. Her uncle works for Nissan so we qualified for the “Family discount” and didn’t have to haggle the price to get the best they could give me (supposedly). I took a few finance classes in college and knew how to calculate NPVs and such. I also had really good credit. The dealership had two incentives, either 0% interest or $2000 cashback (something like that). The standard rates I was qualified for were something around 3.5-4.5% depending on the term of the loan. We eventually decided to take the cashback with a 5-year loan. The $2000 cashback gave us instant equity in the car and we paid at the 4-year rate. Eventually we picked up steam and paid it off in about 2.5 years.

  10. I really liked these tips. I too buy only the used car and for the same reason which you have outlined. Two of my used cars have lasted more than 5 years and i bought these at pretty low prices after hard bargaining. Personally, i do not like monthly commitment since my balances keep fluctuating widely.

  11. Hi David, great post. I couldn’t agree with you more. I’m writing from 10 years experience from working in the car finance industry in the UK and my advice to people is to always purchase a car that is a few months old or older as with new cars you get hit with a large chunk of depreciation as soon as you drive it off the dealers forecourt. Businesses may wish to lease vehicles as it suits them but for personal usage I’d definitely finance an amount over 36 months or 48 months if the repayments on 36 were too high. A large cash deposit is always a bonus if you have it but always try and put in 10% minimum. My last tip would be to barter with the finance company to get the best deal. Say you’ve been offered a slightly better rate from another finance company and then you’ll see how much they want your business ;-)

  12. Some thoughts -

    Buying a car is actually quite simple. All that is needed is a bit of knowledge and an understanding the buyer is in complete control at all times. A buyer can walk at any time. Dealers know this and a savy buyer will use this to his/her advantage.

    A savy buyer does not really need to worry about depreciation if the buyer buys at the right time. That time is when dealers are willing to deal. I have purchased many vehicles, usually one a year, for the past five years Each vehicle was purchased at or below the posted dealer invoice. Buying low covers much of the depreciation.

    A savy buyer would not put anything down on a vehicle. First buy at the right time. Second buy a vehicle which has a good manufacturer finance rate. Putting money down on a vehicle only saves interest. If the buyer gets a low interest rate, or better a zero percent rate, putting money down doesn’t save much. In any case, by not putting any money down the buyer would have the money in the bank, which is better than having the money in the vehicle.

    Regarding interest rates. I have always researched (once again) available finance rates. I have never found a dealer not willing to beat the best interest rate I was able to obtain on my own. Dealers make money off the financing (in many cases) and will do anything they can to get the buyer use their financing. There is nothing to lose by letting the dealer have a shot at the financing. If the bank offered 5 percent, the dealer might come back with 4.5 percent. A buyer will never know unless they ask.

    A savy buyer should always consider the monthly payment. The key is for the buyer to come up with the monthly payment for his/her terms for the desired vehicle. This is down via research. The buyer researches the selling price of the vehicle, arriving at his/her desired price. The buyer researches the value of the trade, arriving at his/her desired value. The buyer researches finance rates, arriving at his/her desired rate. The buyer than uses one of the many on-line calculators to determine the monthly payment using the desired selling price, trade-value, and finance rate.

    It really does no good to “hide” the trade. Dealers are not stupid. To the dealer, all three factors (price, trade, finance) are part of the same deal. The selling price and the trade are not, as too many so-called experts suggest, two different deals to the dealer.

    A savy buyer does not really need to be concerned about how the dealer structures the deal. Of course in many states a tax break is available for the value of the trade, so having the dealer increase the trade value which is offset by an increase in price would actually benefit the buyer by lowering the amount of sales tax required. A sale to a private party or Carmax eliminates this savings. This can be a significant consideration if the value of the trade is high.

    If the buyer has done his/her homework correctly, the buyer will know a good deal (different for every buyer) by the monthly payment. If the buyer computed a monthly payment of $400 and the dealer comes back with $425 the buyer might conclude the deal is not acceptable.

    The final bit of advise for any buyer is to simply say NO to anything and everything offered in the F&I department. Anything offered can be purchased later from other sources for a much lower price. It is always better to take time to consider the various items offered in F&I. How many times have we all bought something at the moment and later wished we had not.

  13. i do auto loans at a local bank and i almost always recommend going through a dealer. For used cars, some banks will only loan up to 80% of the selling price, minus TT&L. if you’re fortunate enough to have 20% to put down then that’s great, but in this ecomony I find that to not be to the case.

    if you currently owe on a vehicle and want to roll the remaining cost into a new vehicle loan, we won’t do that either, so make sure if you go shopping on your own, you ask these kinds of questions.

  14. Thanks for this article,David. I agree with the short term. I never getting car credit more than 2 years, if I can make a years I will do it even with higher payments per month.

  15. Just a question….very informative by the way….but If I were to pay cash up front for a brand new car from a reliable dealership should they waive off the sales tax in ny and doc fee?

  16. Mike Munzo says:

    Hi, I recently Bought A Luxury vehicle in a Pasco County Dealership in Florida, I had already been approved for $xx.xxx amount at 3.99% Interest for up to 72 months. I arrived at a Dealer near where I live and inquired about a recent Model Luxury Sedan by a Korean Automaker. Test Drove the vehicle, loved it!, negotiated the price and a good trade in price for my vehicle. As I was about to fill the Blank check that the bank had provided me after being approved, a finance person from the dealership approached me and stated that he could get me a better rate depending on my credit, so I filled a credit app and the finance agent returned with good news, stating that he had me approved for 0.5% less than my bank gave me (3.49%), I agreed and stated that my FCU offered me gap protection for a 1 time fee of $300.00, the finance person stated he would meet that price for gap insurance, 2.5 hours later, I was told that the vehicle and paperwork were ready. The finance agent laid all the printouts on top of each other and asked me to sign each form while explaining what i was signing, though he never showed me the bill/invoice with the totals, he just covered the top and right of the page and asked me to sign, I did, the Finance agent cut out all the copies and folded them into an envelope, it was late at night almost 10:20 pm after I had signed all docs, I asked for the bill and was told it was signed and inside the envelope, as I walked towards the sales agent the finance agent got in his car and left in a rush, I was suspicious of his behavior and decided to check the paperwork when i got home, the agent had charged me an extra 1% interest (4.49%) and charged me full retail on the gap insurance ($650). I have been speaking with the sales and finance managers w/o any progress, I had to contact the automakers finance dept to see if this can be rectified, the sales agent went to my defense stating the rate and conditions that I had demanded and had been offered were true / accurate and the dealership threatened to fire him if he didn’t side with the company that pays his salary. The lesson here, nobody will look out for your interests better than yourself, so take your time and be aware that your loss is their gain and they are out to take as much money as they can from you, least pleasant vehicle purchase ever!! I will never buy another Hyundai vehicle from New Port Richey Hyundai ever again!!

    • Gordon Walker says:

      Hey, I had a similar experience at this same dealer with a Hyundai Sonata Turbo, I was fortunate enough to double check all the docs before I left and noticed that the finance dept had also increased the rate, the extended warranty and the tire pack warranty on my vehicle to almost $1100 above what had been negotiated + the the difference in the interest rate, when I called them on it the finance guy seemed annoyed and blamed keyboard error. I stormed out of there and bought the car at another Hyundai dealer, which apologized for the inconvenience and offered me a better deal due to the other dealers behavior. I was even encouraged to report them with the manufacturer. BTW 2011 Sonata Turbo is awesome. I hope more people read this and look back and compare what they negotiated vs what they paid and I am sure discrepancies will abound. GW

      • I hope someone helps me the answer my question.I
        I just bought a car which is brand new car with just Hail damage. I had 34% discount. It is a good deal. I have lower 700 credit score according to dealer. Credit comma shows upper 700. I don’t know why they are different.
        Dealer and one unknown woman try to convince me to get warrenty. (How I was stupid to trust this totaly unknow woman). Anyway, I signed 3000 more money on my contract for warrenty. I was upset with this result. I met my friends, they told me tI should cancel. I canceled the warrenty . Thank God. I just found this site.After I read Mr. David Weiler’s article, I feel like I shouldn’t have 5.9% car loan with 7 year payment.
        I put 20% down payment on my car. One of teachers at my school got 3% with mid 600 credit score. I asked them how I got almost 6% rate.They said my car has hail damage. That is why my intereste rates goes double.
        I checked this under 30 site. Mr.David said I can go local credit union> I might go to the bank I have account. I still want to get this car. I love this car. It is a very good car. So now my current situation is I bought a car and put 20% down with 5.9% rate because the car has hail damage. Some said I can even cancel my contract within 48 hours. I do not wish. I just want to know if I can get better car loan with this situation.

  17. Well my name is Kevin. My first credit card was opened 1 year and 3 months from now and I have a 670 fair. credit score. Awesome right? for this short time.
    I’m looking to buy a used suv in about 3 months and I will try to make my credit go up to 700 this 3 months. I have 4 credit cards revolving.
    In 3 months I will try bank loan before hitting the dealer.
    I know that you can apply for a home loan or car loan a couple of times between a 30 day period and it will appear in the credit report has only 1 time.
    Thats good to know for everyone to make a good research without fearing your credit will go down.

  18. I got a pre-approval from my local credit union for 2.09% for a used car (I ended up getting a two year old model). When the salesman said that 3.5% was the best possible rate and it couldn’t be beat, I had a hard time not laughing. I didn’t need to negotiate with the dealer, but it felt a lot better walking to the dealership knowing I held some cards that they didn’t know about. When I first considered buying a car, my plan was to pay off the car as soon as possible or even pay cash, but with such a low interest rate (likely lower than inflation over the next four years), I’m planning on not spending an extra cent on this loan and instead concentrating on paying off my higher interest student loans (highest are at 6.8%) and starting an investment account.

    Another thing I haven’t seen mentioned: how will you pay to repair that car. This topic fits into the topic of financing in part because the dealership may try to roll an extended warranty into your loan. The salesman of course laid it on thick about how horrible it will be if the engine dies and you have no warranty, but my research (and common sense, since the warranty is a major source of their profit) revealed that most such warranties end up being bad investments. Instead of putting the extra $1100-$1600 on a warranty (and instead of locking myself into getting repairs at this particular dealership), I’m setting aside an extra $100 per month into savings as a car repair fund; if it’s never depleted from car repairs over the course of the car’s life, I’ll be able to roll that over into the cost of the next car.

  19. courtney says:

    this article was much needed thanks. learned alot

  20. alex g. says:

    The information on this page was really helpfull thanks for clearing my confusion with financing

  21. One more thing. My friends told me buyers can cancel entire car contract within 48 hours. I asked the bank. They were not sure
    I don’t want to cancel my contract.I just want to cancel my loan contract which they offered 5.8%. Now banker told me that they could give me 3.5% flat. They just wonder if the loan manager asked me to pay early cancelation fee.
    Because I just bought a car Saturday afternoon(which is yesterday). Then, I would like to cancell current loan on Monday aftter 3:30. Do I need a cancelation fee? or I don’t need.
    Bank told me that if a dealer asked for cancelation loan fee, just paid. They will cover. But my friend told me that just leave the current loan which is 5.9% and pay entire using my new loan when it’s time to pay my first month car loan payment.

  22. Great post, David. I maintain a blog for an auto finance company, and we’re always trying to talk people into getting an affordable, reasonable vehicle with 10-20% down and the shortest term possible. Unfortunately, we see so many consumers who have “the fever” – they NEED this or that new car. They’re myopically-focused on the monthly payment, and nothing else: not how much total interest they’ll pay, not how much risk of negative equity they’ll have, and not how long it will take them to pay off the vehicle. The result can be defaults, repossession, and wrecked credit. Pre-arranged financing, which as you said is a big bargaining chip, also minimizes the risk of rate-padding, where the F&I guy tells you you’re approved at 9.95% APR, when the lender really approved you for 7.95%, and he gets to keep the profit. Great post all the way around. I couldn’t agree more with your recommendations here.