Let’s face it, most people need to borrow money to buy a car. Only 1 out of 10 new car buyers buy with cash. This is one reason why auto loans are the third most common loan in America, trailing home mortgages loans and student loans. Because so many people need to take out an auto loan, it is very important to have a high credit score to qualify for the lowest interest rates.
Pay In Cash
If you are able to pay for your next car with cash, pat yourself on the back! Whether you are the first owner or the third owner of your new vehicle, not having a car loan can be a great feeling. By not having a car loan, the money you would be putting towards a monthly car payment can be invested in a Roth IRA account, pay down other loans, or just about anything else.
When paying in cash, keep in mind that you will also need to pay an additional amount of money above the sales price of the vehicle for registration fees and taxes. Each state charges a different amount, but you can expect to pay more for a $20,000 vehicle than a $5,000 vehicle.
Your Credit Score Determines The Interest Rate
There are several factors that contribute to securing an auto loan. This includes your income and credit history, but your credit score is also important. This three-digit number is what tells the lender and the finance guy at the dealership whether you have good or bad credit. The higher your score, the lower the interest rate on the auto loan.
Here is a breakdown of what type of interest rate you can expect with your credit score if you decide to finance a new car loan:
|Estimated Interest Rate For A New Car Loan (Newer than 2 years)|
|Creditworthiness||Credit Score Range||Estimated Interest Rate|
|Credit Needs Improvement||619 or lower||6.99%|
The above table is only a guideline to show how interest rates increase as credit scores decrease. Interest rates will be higher for a used vehicle that is older than two years. Also, lenders will rate credit scores differently. One bank might require you to have a credit score above 750 to get the lowest interest rate, while the dealer might offer the same interest rate if your credit score is around 720.
Another factor that makes it difficult to estimate your interest rate is that auto lenders use the FICO Auto score instead of the traditional FICO credit score that you can access. Only lenders & dealers have access to this credit score, so it’s impossible to obtain this score before visiting the dealership. You probably will not find out the score until you are signing paperwork to initiate the car buying process.
The FICO Auto score has a similar score range (350-900) to the traditional FICO but puts greater emphasis on payment history with previous auto loans and installment loans. It’s not uncommon for the score to be a couple points different.
What If I Have A Low Credit Score or No Credit History?
Most lenders will only offer decent interest rates to “prime” borrowers with a credit score of 620 or higher. A credit score between 500 and 600 normally falls into the “sub-prime” category with most lenders. The interest rates will be higher than the rates paid by prime borrowers. Also, some traditional banks might not consider lending to “subprime” borrowers. You may have to find an alternative company or dealership.
Don’t worry, if your score falls into the “sub-prime” category you should be able to get a car loan. But, it will most likely have to be through a special financing service or a dealership that specifically advertises financing for those with low credit scores. Just remember that interest rates will be noticeably higher than those advertised to prime borrowers. If the interest rates are too high, you may have to consider a cheaper car to ensure you can make the monthly payments.
If you have a low credit score or virtually no credit history (even with a good credit score), the lender might require a co-signor on the loan application. Having a co-signor reduces the lender’s risk in case a borrower misses payments. They have a backup source to pay the monthly installments. Having a co-signor might also allow you to get a lower interest rate compared to obtaining a loan outright. You can read more about co-signors and how to acquire an auto loan with a bad credit score here.
Credit History and Proof-Of-Income
Two additional factors that lenders look at is your credit history and employment history. Loan officers value both pieces of information as much as the credit score which is a short summary of your credit history. You might have an “Excellent” credit score of 770 but have not had any previous car loans. Lenders look at your credit history to see if you have made payments on-time for any type of loan or credit card in the recent past.
Because lenders look at the FICO auto score, they place the greatest value on prior car loans. They might give you some grief if the only loan payment history you have is student loans. It isn’t the preferred type of loan when determining an auto loan interest rate.
If you have a little credit history or are currently repairing your credit score, the lender will most likely ask for your two most recent paystubs for proof-of-income. If your take-home pay is high enough, this also will allow you to qualify for a low-interest rate and eliminate the requirement of a co-signor.
Another proactive action you can take is getting pre-approved for an auto loan through your bank. You might already be receiving the e-mails and brochures periodically from your bank about these pre-approval offers. While obtaining an auto loan isn’t as rigorous as getting a home loan, getting pre-approval can only help you. Dealers will take you more seriously during negotiations. The pre-approval also gives you a starting point with an interest rate and loan limit. For example, you are pre-approved for a 36-month loan at 2.49% interest up to $25,000.
Just as you will probably visit several different dealerships to find your ideal car at the right price, you should also compare interest rates from different banks. If you are pre-approved, you already have a baseline to compare to other bank rates. If you know your credit score, most banks have a detailed breakdown similar to the table earlier in this article. Most do not publish the credit score ranges (i.e. 720 is “Excellent” at Bank A but Bank B requires a 750 to get the “Excellent” interest rate), so you will have to ask if they can disclose that information to you. Interest-rate shopping will allow you to get the lowest rate for your credit score.
Depending on how much you can get a car loan for, you might have to pay a down payment as well. One approach is that the down payment can be the registration taxes and dealer fees. These can finance the cost of the car or put down 5% of the selling price. Each person has different financial circumstances. Keep in mind that the less you borrow, the lower your monthly payment.
Another expense to think about before purchasing a vehicle is car insurance. If you take out a car loan, the lender will require that you carry collision and comprehensive insurance for the duration of the loan. If your current vehicle only has liability insurance, your monthly bill will be significantly higher carrying these additional policies. Insurance companies will give you a free quote if you buy a particular vehicle. If you are not pleased with the quote, you can “insurance shop” and try to find a lower quote for similar coverage.
Also, car insurance is cheaper for drivers older than 25 years old. So if you are an 18-year old eyeing a nice sports car but can only buy one with a loan, you should probably get an insurance quote first. You might be able to afford the monthly loan payment, but not the monthly insurance payment. If that is the case, you should probably wait a couple years before buying this car as the rates will drop if you have a clean driving record.
Buying a car is more complex than simply going to the dealership and driving home in a new vehicle. While obtaining a car loan is less complex than applying for a mortgage, banks still put great emphasis on your credit score, credit history, and current income earnings. The better prepared you are beforehand (knowing your spending limit and how much you can borrow), the better you can get the best deal.