Too often, auto financing becomes the bane of a car shopper's existence. This is especially true for shoppers with compromised credit who are not eligible for the attractive 0% APR rates flaunted by automakers. Two of the most common mistakes car shoppers make in the auto loan process include: being laser-focused on the monthly payment, and not shopping around for the best auto loan offer. By looking at the bigger picture when selecting a car loan, buyers can expand their options, save hundreds of dollars in interest costs, and protect themselves from taking on too much debt. The following three components should be considered in addition to the monthly payment when selecting an auto loan.
1. Interest Rate
The car loan interest rate is just as important, if not more important, than the monthly payment. This is because auto loan APR rates comprise the second-largest expense when buying a car after the vehicle's purchase price. Depending on a shopper's credit score, APR rates on a car loan can range from as low as 0% for consumers with excellent credit up to 20% or higher for shoppers with subprime credit scores.
We'll look at one auto financing scenario to demonstrate how interest rates will impact your car loan. Let's say we purchase a vehicle for $30,000 and we take out a loan for $25,000 with a 60-month loan term. If the ARP rate is 4%, the total costs in interest add up to $2,600. If we accepted a car loan with an APR of 12%, the total interest adds up to $8,360 which is $5,760 more over the 5-year loan.
To save hundreds or thousands of dollars, you should avoid jumping at the first auto loan offer you receive. Instead, comparison shop for the lowest interest rate through banks, credit unions, or online lenders. Remember that your interest rate isn't only determined by your credit score. Factors such as the lender type, car loan term, down payment, and buying new vs. used will also play a role. Shoppers with excellent credit can usually find a good APR rate at the dealership's F&I office, but those with lower credit scores should get pre-approved and comparison shop before heading to the dealership.
2. Car Loan Term
Car shoppers that solely focus on keeping their monthly payments as low as possible are more likely to select a long-term car loan that spans 84-months or more. Although the monthly car payment should fit into the budget, it is just as important to keep the car loan term as short as possible. A 60-month term or shorter is recommended for a new car purchase to keep interest rates down and avoid the financial risks of going underwater on a car loan.
The first problem with long term auto loans is that interest rates can skyrocket when a loan is stretched out. Interest rates usually increase for loans over 60 months and may even double. For example, instead of paying 3.2% interest on a 3 or 4-year car loan, you’ll be paying 6.4% on a seven-year car loan. When you're car shopping, the salesperson may tempt you with a more expensive vehicle by offering a long-term car loan with lower monthly payments. It's best to avoid this scenario and to address the financing separately from the price of the vehicle.
Secondly, a long term car loan can put you at a higher risk of owing more on the vehicle than its worth. If you need to trade-in or sell your car before your loan is paid off and you're upside down, you'll either have to cover the difference out of pocket or risk falling into a negative equity cycle.
3. Total Cost of the Loan
After you're pre-approved for one or more auto loan offers, you should calculate the total cost of the loan for each financing option. The total cost of your loan will include the dollar amount borrowed (or the cost of the vehicle minus your down payment) plus the total interest you will owe over the lifetime of the loan which will depend on your APR rate and loan term. Remember to factor in sales tax and all additional fees when calculating the 'out the door' price for your vehicle.
Before signing off on a car loan contract, you should read the fine print carefully to understand what fees and penalties you might encounter while paying down the loan. Most borrowers are aware of late fees for auto loans, but some lenders also have early repayment penalties which require you to pay an additional fee if you decide to pay off the loan early. Savvy car shoppers not only shop around for the best deal on the price of the vehicle, but also for the best auto loan offer by calculating the total cost of the interest, loan terms, and potential fees.