Buying a Car with a Loan
For most people, buying a car involves looking at many different makes and models, making a selection, negotiating the purchase price and financing that car or truck. The experience can be exciting, or it can be stressful. The excitement comes from finding the car or truck that's right for you, with the features and style that match your needs and personality. From the test drive to the "new car" smell, even if it's only a new car to you, this part of the shopping process can be the most enjoyable.
Then there's the financing and price negotiation, dealer add-ons and mountains of paperwork. Since 1919 — when General Motors Acceptance Corporation (GMAC) was founded to help sell GM cars, people have used loans to buy their cars. Financing might come from a bank, credit union or other direct lender, or it can be handled through the dealer. And if you finance through the dealer, more negotiation is required to get the most favorable deal. It's easy to become impatient and frustrated; however, with proper planning and a good strategy, closing on a purchase can be stress-free.
How Much Should You Spend?
The first step of buying the right car, with the best auto loan, is coming up with a budget. Start by calculating the total amount available for the car. Many financial experts recommend that you spend no more than 20 percent of your annual income on this purchase. For example, if your annual take-home pay is $38,000, the total annual amount you should spend is $7,600 or $632 every month. Before maxing-out your budget, it's important to note that this figure should include the cost of interest, insurance, sales tax, registration and other fees required at closing. If the insurance, tax and registration cost $200 per month, then the final monthly payment needs to be $432 or lower.
Additional costs include:
- Dealer fees
- Manufacturer fees
- License and registration fees
- Sales tax
- Tag fee
- Title fee
- Extended warranty offers
- Other add-ons (car security, satellite radio, etc.)
Once you determine an affordable monthly payment amount and down payment, you can start shopping for vehicles in your price range. Financial experts recommend a 20 percent down payment and a 4 year financing period, although your needs will likely be different.
Lenders are regulated by the Federal Trade Commission and have certain rules they must abide by. These laws are designed to protect consumers from unscrupulous practices and insure that financial transactions are understood before being entered into. Many states have stricter consumer protection laws as well.
Current Federal Laws
- Truth in Lending Act
- Consumer Leasing Act
- Credit Practices Rule
- Equal Credit Opportunity Act
- Fair Credit Reporting Act
- More consumer protection information is available here.
Auto Loan Basics
Like all loans, car loans come with a variety of terms and conditions that affect the minimum monthly payment and total amount of the loan. These terms and conditions include the length of the loan, interest rate and down payment amount.
The term length is simply the amount of time required to pay back the loan. Some consider a four-year term ideal, while others choose longer periods. Most lenders offer standard 3 year (36 months), 4 year (48 month), 5 year (60 month) terms and 6 year (72 month) terms, although it is possible to find terms that extend for up to nine years.
Longer term lengths offer lower monthly payments, though usually at a higher interest rate. Shorter terms offer the lowest interest rates but monthly payments are higher.
The interest rate is the key factor in determining the total cost of the loan. Rates are based on the credit-worthiness of an individual, which are reflected in the credit score and credit history. Current income, loan amounts and other variables are used in the approval process. Larger down payments can impact the loan amount and interest rate, as can the institution offering the loan. Consumers looking for the best rate should shop around to find the best rates.
The down payment is the amount of the purchase price that is paid up front. A 20 percent down payment is recommended, although not required. People with the best credit may qualify for 0 percent down payments offers.
Many consumers pay their down payment by using the trade-in value of their car or truck.
Car Loan Financing Options
Consumers have many options available when shopping for a car loan. Customers with good credit have more options than those with poor credit. If you do not know how your credit is, visit our credit report page and order your free credit report. The higher your credit score, the less you'll pay in interest. If you have bad credit, options are still available.
Auto loans are secured loans, which means they are secured by collateral (in this case, the vehicle). If the loan is in default, the car, truck or other vehicle can be repossessed. Because of this, secured loans have lower interest rates than unsecured loans.
Dealer Financing: This option is available through the dealership and may include offers from both prime and subprime lenders. Many dealerships and automakers have their own lending institutions and sometimes have special financing rates for certain vehicles.
With dealer financing, loan applications are evaluated electronically through a credit report analysis. Loan applications are then offered to a variety of lenders who will make offers to buy that loan at a certain rate (buy rate). If the dealer is offering incentives, these will be factored in before the offer is made.
Dealer financing can be advantageous; however, if there are no buyer incentives or special offers, borrowers may find better rates from banks or credit unions. If your credit is subprime, subprime lender may be selected. Subprime loan can lower your credit score — if a direct loan is available from a prime lender, it might be the better offer.
Direct Loans: Direct loans (also referred to as personal loans) are made directly to consumers by banks or lending institutions. Credit history and credit scores are considered for loan approval, but other factors are included as well. Banks that have relationships with their customers might be more flexible in the offers they extend to these customers.
Credit Unions: Direct loans are also offered through credit unions. The major difference between banks and credit unions is that credit unions almost always have lower interest rates (and fees) than banks, making their loans more favorable to borrowers. Credit unions occasionally offer special rates or partner with local dealerships to offer incentives for their members. Many credit unions are now open to the general public.
Navigating the Application Process
One way to save a great deal of frustration is with a pre-approval letter from a bank or credit union. This letter notifies the dealership that you've been pre-approved for a certain loan amount and you don't require dealer financing. Not only does this take the pressure of dealing financing away, it gives you and the sales-person, a pre-determined price to work with.
The pre-approval process is the same as that for a regular loan, with the exception that the buyer has to provide the purchase details after signing.
Lenders will need the following documents and information to process a loan application:
- Valid identification (State-issued driver's license)
- Proof of residence
- Proof of income
- Credit report
- Current auto insurance
- Vehicle information
For pre-approval letters, lenders ask for the type and style of vehicle you are shopping for. Detailed information about the car is required once the car is purchased.
After the car is chosen, the loan is agreed upon; various legal documents have to be signed. Reading and signing the papers may take as long as an hour, but when everything is completed, the keys are handed over and you get to drive the car home.
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