There are many reasons why getting a traditional auto loan is challenging or simply impractical for car shoppers. While most car buyers find an auto loan through the dealership or a bank, these routes won't work for everyone. Having bad credit or low income can make auto lenders reluctant to approve your loan application. Purchasing an older vehicle or buying from a private seller can also make finding a car loan difficult. There are a handful of alternative ways to buy a car, and some pose more risk than others. We cover the benefits and drawbacks of each to help you choose the best path for you.
1. Home Equity
If you own a home and have equity in it (meaning you owe less on the mortgage than the house is worth) you may be able to use a home equity loan or a home equity line of credit to pay for a car purchase. Taking out a home equity loan to buy a car means the loan is secured by the home instead of the vehicle as with a traditional car loan. There are benefits to this type of loan, but as you can imagine, there is also a big risk involved.
The benefits of using home equity to finance a vehicle include potentially lower interest rates, flexible terms with a longer repayment period, and the ability to pay off the loan early which may not be possible with a traditional auto loan. One drawback is you'll decrease your home equity which can pose a challenge if you need to sell your home before it's paid off. The biggest risk with a home equity loan is that your home will be in jeopardy if you can't make your payments.
2. 401(k) Loans
Although it's uncommon, it may be possible to finance a vehicle with a 401(k) loan. Not every 401(k) plan will allow you to borrow money for a car purchase, so it's important to check the details of your specific plan. Borrowing money from your retirement savings may not sound like a smart idea, but according to Investopedia, it can be a good choice for a serious short-term liquidity need (a necessary purchase that can be paid off in about a year). If you're looking to buy a low-priced used car, a 401(k) loan may be a better choice than a payday loan which comes with very high interest.
There are both cost and convenience benefits to a 401(k) loan. Since there is no cost other than an administration fee, you'll save on the interest rate that is typically charged for the auto loan minus any lost investment earnings on the principal. Requesting a loan is also quick and easy with no credit check involved so you won't have to wait to purchase your vehicle. There are also drawbacks to a 401(k) loan with the most obvious being the lost earnings on the amount you withdraw. You should also consider that the repayment comes straight from your paycheck, and if you lose your job, you may have to repay the full balance in 60 days.
3. Pay Cash
Paying cash for a car poses the least amount of risk compared to other alternatives, and it can be a great choice for some car shoppers. There are many good reasons to pay cash for a car. First, you'll save on the interest that comes with a traditional car loan. Depending on the rate, the savings can be substantial. For example, a 60-month $20,000 car loan with a 9% interest rate will result in total interest costs of $4,910. Paying cash will also force you to purchase a vehicle you can afford and own it outright. If you have compromised credit, your score won't prevent you from getting the car you need.
On the other hand, paying cash for a vehicle may limit the selection to low-priced vehicles that are older and/or have higher mileage. If the vehicle breaks down and needs costly repairs, any savings you gained from paying cash can quickly be negated. If you're buying a vehicle from a dealership, paying cash could mean losing your negotiating power to get a better price. Dealers profit off vehicle financing and when you pay cash, they will likely not budge on the price of the car to make up for the lost opportunity.
4. Credit Card Cash Advance
According to Consumer Reports, a credit card draft or cash advance can be used to buy a vehicle, but it's a risky move. A cash advance is a short-term loan offered by your credit card company that allows you to borrow money against your card's line of credit. The funds can be used for a vehicle or any other purchase. A benefit to using this type of loan is that the process to get a cash advance is quick and simple. It can be done at an ATM or in person at your bank and you may be able to use a convenience check to write a check to yourself for the amount needed to buy the vehicle.
On top of higher interest rates, there are usually several fees involved in taking out a credit card cash advance such as a cash advance fee of 5%, for example. Cash advances often come with low introductory APR rates which can be misleading. The low rates will climb once the introductory period expires, and if you're just one day late on making payments, the rates will rise even higher.
5. Alternative Auto Loans
Car shoppers with bad credit often run into obstacles when applying for a car loan at a traditional bank or dealership F&I office. Alternative lenders that specialize in helping customers with compromised credit include subprime auto lenders and Buy-Here-Pay-Here dealerships. Both options offer more flexibility in approval, but each comes with some risks as well.
Subprime auto lenders specialize in helping customers with a FICO score under 650, low income, no credit history, a debt-to-income ratio over 50%, a bankruptcy in the last 60 months, self-employed, new business owner, or retiree. Buy-Here-Pay-Here (BHPH) dealerships sell and finance vehicles in-house and a steady income is usually the only requirement to qualify.
Although both options help customers get into a vehicle, the auto loan usually comes with higher interest rates or down payment requirements. BHPH dealerships also have strict payment rules, carry a higher risk of repossession, and may even GPS track the vehicle until it's paid off. Getting a car loan through a subprime lender is the preferred route for most car buyers.