Taking out a car loan is a major decision that goes beyond a monthly payment. In some ways, auto loans can be as complicated as mortgages with dealership promotions, down payments, prepayment penalties, and fees to consider. Before taking out a new auto loan, make sure you know the following.
1. Fees and Taxes Will Increase the Loan Amount
The sticker price on the car is only the beginning of what you will pay. There will also be a documentation fee, registration fee, and sales tax. All of these fees vary by area and the documentation fee varies by dealer. The documentation fee alone may be up to $500. Depending on your credit score and how much you are borrowing, you may have the option to roll all of these fees into your new car loan. This reduces your upfront cost, but you may be paying off these fees for years with an interest rate at 15%.
2. You May Have Negative Equity
Negative equity refers to owing more than your car is worth. This is a guarantee if you finance a new car without a down payment. Depreciation begins as soon as you drive a new car off the lot, when it loses about 10% of its value. During the first year, the average car loses about 20% of its value. Over the course of the first five years of its life, a new car loses 60% of its original value although some cars depreciate faster than others.
The more money you put down, the less you need to finance. This can also reduce the risk of negative equity that can come back to hurt you later if you need to trade in the car or you are involved in an accident.
3. Your Credit Score Is a Big Deal
Your credit score is one of the biggest factors affecting how much a car loan will cost. When dealerships and banks advertise low interest rates, they are usually only available to borrowers with the best credit score. In fact, most financing options are only available to well-qualified borrowers such as dealership financing deals. Before applying for a car loan, order free copies of your credit reports to correct errors and take steps to improve your credit, such as paying down debt.
4. Get the Shortest Term You Can Afford
About 40% of new car loan borrowers have their car loan longer than their car, according to a report by the Consumer Financial Protection Bureau. The report found 42% of new car loans have a term of 6 years or even longer. While a longer term will mean lower payments, it extends the amount of time you will spend paying off the debt, dramatically increases the interest you pay, and increases the chances that you will owe more than your car is worth. If you can afford it, stick with a 3-year car loan and avoid loans of 6+ years if possible.
5. You May Need Gap Insurance
When you buy a new car, it begins to lose value as soon as you drive it. If you didn’t put down a large enough down payment, gap insurance is a smart investment. If you are involved in an accident that seriously damages or totals your car, gap insurance pays the difference between what your car is worth and what you still owe on your loan. Without gap coverage, you will be responsible for the remaining balance even though you no longer have a car.
6. Make Sure You Know How Dealership Rebates Work
It’s common to see dealers and manufacturers offering great incentives on new car purchases. If you qualify, a rebate can potentially lower the purchase price of your car and reduce financing costs. New car rebates are usually $500 to $5,000 and apply only to specific models. In most cases, these rebates work like an extra down payment on the purchase. It’s important to understand that these rebates are offered by the car manufacturer. You can still negotiate with the dealer and potentially get other incentives, but some are offered in lieu of other incentives such as special financing.
7. Get Pre-Approved Before Shopping for a Car
It’s a good idea to go to a car dealership with a financing offer already in hand. This ensures you have a loan that will cover the purchase of a car, but it also gives you leverage. Don’t assume that the dealership will automatically offer you the best rate. Before searching for a car, compare rates among several lenders, including banks and credit unions, before seeing what the dealership has to offer to find the loan that will offer the best terms.