A Guide to Auto Loans for 2020
One of the benefits of auto loans – which can actually be a problem – is that they’re so easy to get. A problem?
Most auto loans are straightforward. But there are various types of auto loans that contain different provisions. If you don’t know what they are, you could pay too much for your loan.
With that in mind, let’s consider everything you’ll need to know to get an auto loan as an informed consumer.
Auto Loans Can Be “Good Debt”
We sometimes see debates between good debt and bad debt. Good debt usually are the kinds of credit taken in ways that will improve our lives. Examples include using a mortgage to purchase a home or investment property, or a student loan to get a college education.
At the top of the list of bad debt is credit cards. Not only are they used to pay for consumption that typically can’t be covered out of regular income, but they also carry very high rates of interest. And since they’re revolving, they’re the type of debt that can hang around for many years.
But most good-debt-bad-debt debates either cover auto loans only lightly, or ignore them completely.
In reality, auto loans can be either good debt or bad debt – it really depends on how to use them.
An auto loan is certainly bad debt if it’s used to purchase a vehicle you can’t afford, or one you don’t really need.
But in most cases, and for most people, an auto loan definitely falls into the good category. At a minimum, a car has become a necessity in most of the developed world. That’s certainly true for people who live in suburban and rural areas, where there’s no suitable public transportation. A car provides the mobility necessary to get where you need to go, and auto loans enable you to get that car.
The Main Reason Auto Loans are Good Debt
But there’s an even more basic reason auto loans are mostly good debt: auto loans are used to purchase cars, and cars are a very necessary part of how most people earn a living.
Put another way, if you don’t have a car, your ability to earn a living will be very limited. At a minimum, a car is necessary to commute back and forth to a job. But if you’re self-employed, it can be even more important. A vehicle can be an integral part of your business, without which it would be very difficult to earn any money.
When you make the obvious connection between owning a car and earning a living, auto loans take on a whole new and more positive direction.
Typical Terms for Car Loans
The auto loan industry is quite a diverse one, and loan terms can vary considerably from one lender to another. But auto loans typically contain something very close to the following terms:
- Loan amounts between $5,000 and $50,000.
- Terms ranging from 24 months to 84 months (7 years).
- Interest rates from low single digits up to well above 20% (for subprime loans).
Down payments are often the most variable component of auto loans. Many lenders will provide 100% financing, but others may require down payment as high as 20% of the value of the vehicle.
Still, others will permit you to borrow up to 120% of the “blue book value” of the vehicle, as determined by the National Automobile Dealers Association (NADA), Kelly Blue Book, or some other well-known auto valuation service.
Down payment requirements should always be investigated before applying for a loan, particularly if you don’t have a vehicle to trade in for the down payment.
The Subprime Auto Loan Trap
You’ve doubtless seen and heard advertisements from auto dealers promising to get anyone into a car, regardless of credit history. If you’ve ever wondered how they do it, is through subprime auto loans.
Subprime loans have been credited with causing the Mortgage Meltdown back in 2008 and 2009, and they’re no longer available for mortgage financing.
Similar to mortgage subprime loans, subprime auto loans charge very high interest rates. Where you might be able to get 3.99% from a bank or credit union, a subprime loan may come with a rate of 23.99%. The very high rate is to compensate for the fact that the borrower is considered highly likely to default on the loan.
Auto dealers use subprime auto loans to get those with poor credit histories into cars. But you should only take one of these types of loans if you absolutely need a car, and there’s no other financing alternatives.
In addition to high rates, subprime auto loans frequently have the following characteristics:
- Extended loan terms – where banks and credit unions typically make loans running three-to-five years, subprime loans might run six or seven years. The extra interest you’ll pay for the longer term will be thousands of dollars.
- Add-on provisions that increase the loan amount. This may include high cost gap insurance, credit life insurance, maintenance packages, and other additions of questionable value.
- Larger down payments, like 20%. Ironically, this substantially lowers the risk involved in the loan, but that’s never reflected in the interest rate charged.
If you do take a subprime auto loan, do whatever it takes to refinance the loan into a lower rate loan within one or two years. If you make your payments on time, your credit should improve enough to qualify for a much lower rate.
Prepare Your Credit Before Applying
The rate you’ll pay for your loan – or even whether you’ll be approved or not – will depend heavily on your credit score.
Some banks and credit unions will require a minimum credit score of 650 to make an auto loan. But others may look for a higher score, such as 700 and above.
If your score is below 650, you’ll almost certainly be put into a subprime auto loan. Auto dealers work very closely with subprime auto lenders. When a customer comes in who is unable to qualify for traditional bank financing, the dealer will set the person up with a subprime loan.
We’ve already discussed the terms of subprime auto loans, and it’s clear they’re something that should be avoided, if at all possible. The best way to do this is by improving your credit score before you make an application. Raising it from say, 620, to 660, could save you thousands of dollars in the cost of financing over several years.
Get serious about credit repair, so you’ll be prepared for your auto loan application well in advance. Make all payments on time from now on, dispute any errors on your credit report, and pay off any past due balances.
Apart from your credit, lenders also look at your income and the size of your down payment. Making a down payment of 10% or 20% will strengthen your credit application. And as far as income, banks and credit unions usually want to see that your total fixed monthly debts – including your new car payment – will be within 40% or 45% of your stable monthly income.
Making a large down payment, or buying less car than you can afford, can sometimes be enough to keep you out of a subprime auto loan situation.
Auto Loans vs. Leases
A record 4.3 million people are expected to lease new cars in 2019, representing roughly 25% of all new car sales. For that reason, auto leases need to be included in a discussion of auto loans.
Auto Leases – The Good
Leases do have certain advantages over buying a car outright with an auto loan:
- Down payment – Technically speaking, auto leases don’t require a down payment, though most come with an equivalent arrangement referred to as a “cap cost reduction”. The reduction basically serves to lower your monthly payments, and is often satisfied with the trade-in.
- Low monthly payments – Many car dealers advertise very low monthly payments, though these usually are leases with very low mileage allowances.
- Leases are perfect for those who want to trade in their vehicles every few years – You can get a lease that runs for just two or three years, then replace it with a new leased vehicle.
- Warranty coverage – Since a leased vehicle is being exchanged every two or three years, the cars are always covered by the manufacturer’s warranty.
Auto Leases – The Bad
Auto leases come with an at least equal number of potential disadvantages:
- You never own the vehicle – That means you have a liability – the lease – without ever owning the vehicle it finances.
- Nothing to trade in at the end of the lease – Which means you may need to come out of pocket to pay for the cap cost reduction on the next lease.
- You can’t get out early – Actually, you often can. But there are usually stiff financial penalties for doing so.
- Mileage limits – Monthly lease payments are closely tied to the number of miles allowed on the vehicle. The lowest monthly lease payments may limit you to no more than 6,000 miles per year.
- Maintenance penalties – Auto dealers expect you to return a leased vehicle in the same condition you took it. You’ll be charged for excess wear and tear, which can often be highly subjective.
- Complicated provisions – There’s no escaping the fact that lease contracts are more complicated than an outright purchase.
Auto lease arrangements work best for those who prefer to change cars every two or three years, and are low mileage drivers. If you’re not, a lease will cost more than a purchase.
Choosing the Best Auto Financing Company
In most cases, your best auto loan companies will be a bank or credit union, particularly one you already have an established relationship with. That’s where you’ll get the lowest rates and the best terms.
Credit unions tend to be more forgiving on lower credit scores, like those as low as 650. And since you are a member at a credit union – rather than just a customer – they’re also more likely to overlook a credit ding or two.
There are also some online banks well known for auto loans. One prominent example is Ally Bank. The bank operates entirely online, with auto loans being one of their major lines of business. That makes sense, given that Ally Bank is the former General Motors Acceptance Corporation (GMAC). The bank has some of the most innovative auto loan programs in the industry, including leases for used cars.
Once again, if your credit is not sufficient to get an auto loan approval from a bank or credit union, you can usually get financing from the dealer. Just be careful that this is often in the form of subprime auto loans, forcing you to pay higher interest and accept a longer-term.
How to Get the Best Rates on Your Car Loan
When shopping for an auto loan, there are certain strategies you should use:
Buy within your means. Regardless of what a lender says you can afford, keep the monthly payment at no more than 15% of your stable monthly income. 10% is even better. Not only will that make paying the loan easier to manage, but it will also improve the chance of your loan being approved.
Get an auto loan preapproval before shopping for a car. Apply and get an approval before you even begin shopping for a car. Not only will that make you a more qualified buyer when you go to the dealer, but it will force the dealer to come up with a better loan offer if they also want to provide the financing. It will also avoid the possibility of the dealer steering you into a subprime loan – a practice which is not uncommon at certain dealerships.
Keep the loan term as short as possible. You may be tempted to go with a longer long-term, like six or seven years, to keep the monthly payment low. That will also keep you in debt longer, and raise the possibility of the car needing major repairs while you’re still making payments.
Check your auto insurance rate before buying. Car buyers often hold this step until after they purchase the vehicle. But insurance rates can vary significantly from one type of car to another. If you’re interested in a certain vehicle, contact your auto insurance provider to get a quote on the premium. It could be a deciding factor in whether or not the purchase that vehicle.
Watch Out for the Loan Deficiency Rollover!
This is an auto loan tactic used by car dealers that many car buyers are completely unaware of. It works something like this:
You’re anxious to purchase a car but your current vehicle has a $10,000 loan on it, and is only worth $8,000. You may be vaguely aware of this imbalance, but you take a shot and go to a car dealership anyway.
You’re in luck – the dealer assures you that the fact you owe more on your car than it’s worth won’t be a problem for the trade-in. You’re so ecstatic, you don’t even bother to ask why.
But you absolutely need to know how it works, and this is how:
The fact that you owe more on your current vehicle than it’s worth is what’s referred to in the auto sales business as being “upside down” on your car. As long as the dollar amount of the deficiency isn’t too high, the dealer – or more precisely, the dealer’s lender – can work with it.
How? They’ll simply roll the deficiency on your current car – $2,000 – into the loan on the new car you’re purchasing.
Let’s say the new car is $20,000. You don’t have any cash for a down payment, and your current car is in a negative equity situation. But the lender will “fix” the problem by issuing you a new $22,000 loan on your new $20,000 car.
Since the deficiency on your old car will be transferred to your new car, you’ll also be upside down on your new car from the very beginning.
While it may seem like the answer to a financing prayer, it will leave you in an impaired position. Since you’ll owe more on the new vehicle than it’s worth from the very beginning, it will be both harder to sell or refinance. And it should go without saying the monthly payment will be higher than if the deficiency had not been rolled over.
Final Thoughts on Auto Loans
If you’re in the market to purchase a new or used car, never leave yourself at the mercy of a car dealership.
Do your homework – monitor your credit, make sure you have sufficient income for the car you want to buy, and investigate all auto loan options.