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You found your dream car. Now, you need to pay for it. Most car shoppers need a car loan to buy their next new or used car. Check out the car financing basics covered below to make sure you get the best car loan for your new vehicle.
The Basics of Car Loans
A car loan is a way for you to purchase a new or used vehicle. You borrow money from a lender and pay them back over time, usually with interest. The amount you borrow is called the loan principal. Car loans almost always include interest, which is how lenders make a profit on the money they lend you. The interest rate is a certain percentage of the loan that you must pay back in addition to the loan principal. So, if you borrow $20,000 for a car at a 5 percent interest rate, you're going to end up paying the bank $21,000 over the life of the loan -- that's the principal, plus the interest. While you’re paying back the lender, you’re responsible for all taxes, fees and expenses, like gas, insurance and maintenance, associated with owning the car.
Many people think that when you finance a car, the finance company lends you the money and the car is yours. That's a simple way of looking at it. In reality, however, the lender is buying the car and letting you use it. The lender technically owns the car, though you agree to be responsible for it. In fact, you won't have the title to the car and fully own it until you make your last loan payment. If you don’t make your car loan payments, the lender can repossess the car.
The Car Loan Term
The length of the car loan, or loan term, simply refers to the amount of time you have to pay the lender back. If you sign up for a five-year term, in five years you'll pay the money back and will own the car free and clear. The vast majority of auto loans are repaid in monthly installments. You send the lender a set amount each month and slowly pay off the loan.
Your Credit Score
When it comes to how much interest is charged on a car loan, some people get charged more interest, and some get charged less. Obviously, you want to get charged less. The interest rate lenders charge is based largely on your credit score, which is a number that credit bureaus assign to you based on how much debt you have, how good you've been about paying bills on time, how long you’ve been using credit and your debt to income ratio, which is the amount of debt you have versus how much money you earn. Lenders use the score to assess how likely you are to pay them back. If your score is low, lenders will assume that you’re at high risk for not paying the loan back. The higher interest rate is the lender requiring more money to cover that risk. Lenders may also require a larger down payment from buyers with lower credit scores to offset their risk as well.
You should know what your credit score is before you apply for a car loan and do your best to make sure it's as high as it can be. Generally speaking, credit scores of 720 and above get the best loan rates. For a small fee, you can get your credit score through FICO, which is the most commonly used credit score among lenders. You can also get credit scores from credit bureaus like Equifax, Experian and TransUnion. If your score is not as high as you'd like, paying off old bills (like credit card debt) and paying all bills on time for six to nine months should bring your score up and help you get a better interest rate.
You’ll also want to take a look at your credit report to make sure everything is accurate. If someone stole your identity and opened a credit card in your name and you aren’t aware of it, this could affect your ability to get a car loan.
Plus, you’ll want to report the fraudulent activity right away to the credit bureaus so any errors can be fixed before you apply for auto financing.
Apply, Apply, Apply
You wouldn't just apply to one job or one college, so you shouldn't apply to just one lender for a car loan. Contact your bank, local credit unions and other lenders to find out what they're offering. You'll have to fill out loan applications, which will ask for your social security number, employment and income information, monthly expenses, like mortgage and rent, and any outstanding debts, like credit cards and student loans. When you fill out auto loan applications through multiple lenders, be sure to do it all at once, or within a close time frame. Credit bureaus will see your multiple applications and realize you’re shopping for auto financing. If you spread your applications out, keep in mind that multiple applications for financing can lower your credit score. Do all your applications around the same time, so as not to lower your score.
Do not exaggerate your income or misstate your expenses and amount of debt. Everything you fill out on a loan application will be verified and if you lie, you’ll get caught. The lender will pull your credit history and credit score and decide whether or not to make you a loan offer based on that information, as well as your income, expenses and debts.
Look over all the loan offers you get in detail. The interest rate you’re being charged shouldn’t be the only thing you look at. Avoid offers that charge you a lot of fees. Another thing to look at is the car loan term. A longer auto loan might result in a lower monthly payment, but over the long haul, you’ll pay more in interest. Also, watch out for loans that have a prepayment penalty, which is a fee charged if you pay the loan off early. Paying the loan off early may not be something you'll be able to do, but if your long-lost Aunt Mabel dies and leaves you a fortune, paying it off could save you a lot of money, and you don't want to pay extra fees to do it.
Don't Feel Dejected about Getting Rejected
If your car loan application is rejected, you’ll probably feel terrible, but that rejection is likely a good thing. A rejected loan application means the lender didn't think you'd be able to pay the money back. As hard as that is to hear, that lender likely just saved you from getting into more debt than you can handle. Reassess your budget to determine what you can truly afford, not just monthly, but over the life of the loan. Try finding a less expensive car to buy, or save up more money so you have a larger down payment, which will reduce the amount you’ll need to borrow.
Show Up with Financing
Many car buyers might think that the car dealership is offering you the best financing rates. That's not always the case. While you should certainly consider the loan the dealership offers, the best way to get the lowest interest rate is to bring a pre-approved loan from your bank, credit union or third-party lender when you go to the dealership. If the dealership can beat the interest rate, fees and other loan terms you’ve already been pre-approved for, you can decide to take the dealer’s offer. If not, you already have financing.
Bringing your own financing to the table also means you'll have the upper hand when it comes time to sit down with the finance manager. Some dealers will give you a great price on a car, but will charge you a higher interest rate on the car loan, which will cost you more money in the long run. This is an area where dealers can make a profit on the vehicle. With financing in hand, you can focus on the price of the car and your trade-in, if you have one.
Now that you understand the basics of financing a car, you’ll be able to get the best car loan for your budget and your new vehicle.