How to Finance a Car the Smart Way
When I bought my last car, I thought I was being smart because I negotiated a good price and a good interest rate. In hindsight, my first new car purchase was just another one of the many financial debacles of my early twenties. In the financial situation I was in at the time, I had no business buying a brand-new car. I also should have put a lot more money down, and I should have taken out a shorter loan. Put another way, I simply bought more car than I could afford.
What I know now is that it’s always best to buy a car with cash. Still, less than 15 percent of American car buyers purchase their vehicles outright with cash. The other 85 percent take out auto loans. So if you’re going to finance a car, at least do it right.
1. Arrange Financing Before You Shop
If you’re going to finance a car, the biggest piece of advice I can offer is to visit your bank or a local credit union and apply for an auto loan before you start car shopping. Most of the time local banks and credit unions can offer borrowers with good 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. Finally, wherever you apply for financing, know your own credit score before you apply. Lenders use your score to determine your interest rate, and they may try to inflate the rates you qualify for if they suspect that you don’t know where your credit actually stands.
2. Put Twenty Percent Down
Unlike real estate, cars are depreciating assets. In other words, your car is worth less and less every day. So when you finance a car, you run a big risk of becoming “upside down”, a situation where you owe more on your car loan that your car loan is worth. That means if you ever need to, you may not be able to simply sell your car and get out of the car loan. Being smart about your financing is all about avoiding this situation. One simple thing to do is to put money down…ideally twenty percent. The more money you put down, the closer the value of your car will be to how much you owe on the loan. 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!
3. Buy Used
Brand new cars depreciate the minute you drive off the lot. In fact, they depreciate so much in the first year of ownership that a twenty percent down payment may not be enough to prevent you from becoming upside down on your car loan. But buying a used vehicle—even one that’s only a year old—can help prevent this because the biggest chunk of depreciation has already happened.
4. 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.
5. Finance for 36 Months or Less
Ten years ago, most car loans came with two- or three-year terms. As expensive trucks and SUVs grew popular, however, dealers began offering longer and longer car loan terms to make these pricey rides “affordable” to more people. Today, five- and even six-year car loans are common. Unfortunately, if you finance a car for longer than three years (36 months), you can be fairly certain you will be upside-down on your loan, at least for a while.
Car dealers want to make you think that you can afford just about any vehicle they sell. If you’re smart, you will approach buying your next car knowing that is simply not true. Realistically, you can afford any car that you pay for with cash. But if you must finance your next car, at least follow these rules to make sure that your new wheels won’t someday leave you financially stranded.
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Topics: Auto Loans, Cars.
Published on March 22nd, 2010.
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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.
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.
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.
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.
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%.
When changing cars, I always try to pay 30% down which usually comes from the sale of my previous car. This way, I just maintain what I usually pay for my monthly amortization, more or less.
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.
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.