Financing a car? Here’s what you need to know about auto loans.

Buying a car is a big decision, and it can be a little scary. But don’t worry. In this article, we’ll give you the facts about auto financing. Understanding your options can help you save money and take a little stress out of the car-buying process.

3 Ways to Buy a Car

If you’ve looked online or stopped by a local dealership, you know that cars can be expensive, with new models costing tens of thousands of dollars and used vehicles fetching top dollar. Let’s look at a few different ways that can get you behind the wheel – even if you don’t have a ton of cash.

1. Paying Cash
   If you DO have the money, paying cash for a car means you are paying the whole price of the vehicle upfront.

2. Leasing
   This isn’t exactly “buying” a car. Essentially, it’s long-term renting. You sign a lease agreement and make monthly payments for an agreed-upon term, typically three or four years.

3. Financing
   With this option, you use a loan to pay for the vehicle, which can come from a financial institution or through the dealership. If you choose to finance, you’re in good company. According to available data, 85% of new car and 50% of used car purchases use some form of financing.

2 Ways to Finance a Car Purchase

Let’s say you won’t be paying cash and you don’t want to lease, so we’ll look at financing. Financing a car means taking out a loan for all or part of the total cost and then paying it back, over time, with interest. Whichever type of financing you choose, you’ll want to shop around to make sure you’re getting the best deal. Here are two ways to finance your vehicle.

2. Financial Institution
   Also called direct financing, with this option you get a loan directly from a bank, credit union, or online lender. With direct financing, you can shop around and find competitive interest rates. Also, some financial institutions may offer discounted rates to their established customers.
3. Dealership
   With this option, you work with the dealer who will arrange the financing with a lender on your behalf. A car dealer is motivated to make a sale, and they may offer more flexible options compared to financing at a financial institution. This might also be a good choice if you’re just starting to build your credit or have a lower credit score. Dealer financing is also convenient because you can shop for your car, test drive it, and complete the financing paperwork all in one visit.

3 Things That Affect Your Monthly Payment

Now, let’s look at your monthly payment. Here are three major factors that affect the total amount of the loan and your monthly payment.

1. Down Payment
   Depending on whether you have a trade-in vehicle or make a down payment, the loan amount may turn out to be less than the value of the car. Keep in mind that if you put down less money – or none at all – you’ll end up with higher monthly payments and pay more total interest.

2. Annual Percentage Rate
   Usually referred to as the APR, this is the yearly interest charged on the loan.

3. Length of Loan
   This is the amount of time you’ll pay on your loan, generally 24 to 84 months; most people take loans for 72 months. A longer term will significantly whittle down your monthly payment, but you will end up paying more in interest over the life of the loan.

3 Rules for Budgeting

If you want to make sure that buying a car won’t bust your budget, experts recommend applying the 20/4/10 rule.

1. 20% Down Payment
   Your individual financial situation will determine how much you can ultimately afford, but if you make a down payment of at least 20%, you can reduce the amount of the loan and pay less each month.

2. 4-Year Loan Term
   Auto loans for terms longer than four years generally carry higher interest rates. A higher interest rate could lead to being “underwater” on your car loan, which means paying more on the loan than the car is actually worth. Remember that you will also need to cover repairs, gas, and maintenance on your car. Meeting those expenses might be harder if you’re still paying your car off after four years.

3. 10% of Your Gross Income
   A good rule of thumb is to make sure you don’t spend more than 10% of your income on monthly car payments, including loan principal and interest. You should also make sure that your total car-related expenses, including your car payment, insurance, gas, and maintenance and repairs, don’t exceed 20% of your income.

3 Steps to Apply for a Loan

Before you apply for an auto loan, follow these steps to make the process easier and help you find the loan that works best for your financial situation.

1. Look at Your Budget
   You will need to decide how much you can really afford. Factor in the cost of gas, maintenance and repairs, your monthly car payment, and insurance. The interest rate you’ll pay can be affected by your credit history, as well as other factors. Lenders and dealers aren’t obligated to give you the best rate available, so it pays to shop around for a loan that will fit your budget.

2. Gather Necessary Documents
   Once you’ve determined how much you can afford, you’ll want to pull together documents you’ll likely need during the loan process. Requirements vary by lender, but they generally include proof of the following: identity and residence, car insurance, and income. You can also expect a credit check.

3. Apply and Compare
   With your budget nailed down and your documents gathered, it’s time to apply to multiple lenders so that you can compare offers. You’ll want to consider the APR, the loan term, and monthly payment, plus the overall value of the car including make, model, age, and mileage.

The Bottom Line

When it comes to determining the best car loan, there are many things to consider. Taking the time to understand how auto loans work can help you make an informed decision before you buy.

You’ll want to think about what option works best for you. You might opt for a lower payment and a longer term and use what you save to pay down high-interest debt. Or you might opt for a higher monthly payment so you can pay off the loan sooner. And, if you have an existing car loan, you can look into refinancing, which may be able to save you money.

Your financial institution is always ready to help. Reach out if you want more information about financing a vehicle.

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