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Auto Loans 101: Auto Financing Essentials

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Auto Loans 101: Auto Financing EssentialsI’m not a huge fan of auto loans.  I prefer to finance assets that are likely to appreciate over time and/or that receive beneficial tax treatment (i.e. a home, education, etc).  Auto financing doesn’t normally tick either of these boxes.

Vehicles tend to depreciate the second you drive them off the lot, and the interest on auto loans is generally not tax deductible to an individual.

For these reasons, it is generally preferable that a person save up for a vehicle and pay with cash rather than rely on auto financing, if at all possible.  If you do save up for a vehicle, keep this money in a separate interest bearing savings account or money market account so that you don’t accidentally spend this money on something else.

I do recognize that sometimes a vehicle is absolutely imperative (i.e. for a job, to attend college, etc) and that there may not be time to save up for one in certain circumstances.

If you have financed a vehicle you are not alone–about 70% of Americans take out auto loans.  Many consumers spend a lot of time researching the perfect car to buy but don’t spend nearly enough time researching auto loans.

If you must finance, it’s important to understand your options so that you borrow wisely and find the best deal on your auto loan.

Obtaining an Auto Loan

Auto financing generally involves filling out a credit application.  If you are approved for the loan, the lender will give you a credit limit and issue you a check that you will make out to the dealership you purchase the vehicle from.  The lender normally holds the vehicle’s title until the loan is paid off.

Consumers obtain auto loans from a number of different sources.  Two of the most popular sources of auto loans are dealerships and online lenders.

Dealer Financing

A dealership is oftentimes the most convenient source of auto financing since you can obtain both your car and the auto loan at the same place; however, it’s rarely the cheapest alternative for the consumer.

You may pay dearly for this convenience in the form of a more expensive auto loan.  Dealerships should generally be the last place people look for auto loans.

Many dealers have relationships with finance companies.  When potential buyers request auto financing from the dealer, the dealer will obtain the auto loans through the finance company and then pass them along to the consumer, but only after bumping up the interest rate by 1-2% which the dealer pockets.

In many cases, the dealer is just an unnecessary and expensive middleman that can be avoided by seeking auto financing elsewhere.

Auto financing is one of the ways that dealers make money.  If you drive a hard bargain on the purchase price of a vehicle, the dealer may look to make up some ground on the auto financing.

Don’t be fooled by a dealership’s offer of rebates (cash back) or zero percent financing.  Those sound like good deals for the buyer, but the dealer generally makes up for them elsewhere (i.e. higher sales price, etc).

Obtaining auto loans online or at a bank allows people to focus on driving a good bargain based solely on the vehicle and purchase price.  It also takes off the table one of the ways a dealer can make money off of you.

Online Auto Loans

In my opinion, a much better place to go for auto financing is the Internet.  The number of internet lenders out there has grown over the years.  Online lenders oftentimes offer some of the most competitive auto financing rates around.

Being approved for an auto loan before you begin shopping around for a vehicle can greatly speed up the buying process and give you an additional bargaining chip.  Additionally, when you later go shopping for a vehicle, you know exactly what your spending limit is.

Online lenders generally allow you to compare loan terms at a number of financial institutions, ensuring that you find the best deal possible on your auto loan.  Here are a few sites where you can quickly and easily obtain multiple quotes:

Online lenders make it incredibly quick, easy, and convenient to obtain auto financing or refinance an existing auto loan.

Term of the Loan

Try and take out a loan with a term no longer than 3-5 years.  Taking out a loan with a longer term will lower your monthly payments but may significantly increase the overall interest you pay on the loan.  It will also increase the amount of time you are underwater on your loan.

Auto loans with a 6-7 year term have traditionally been charged an interest rate that is 1-2% higher than a more traditional 3-5 year loan, making them more expensive.

Taking out a loan with a 6-7 year term also increases the odds that you may need to dispose of the vehicle before the loan is paid off.  This could lead to you making payments on a vehicle you don’t even own.

If you can’t afford a loan with a 5 year term, the vehicle you are considering may be too expensive.

How to Save on Auto Loans

Here are a few ways to save on auto financing:

  • If you already have an auto loan, see if you could save by refinancing your auto loan
  • Improve your creditThis will help you qualify for the most favorable auto loan terms.
  • Make a large down payment.  This may help you receive a lower interest rate.
  • Keep the term of auto loans as short as possible to save on interest payments.

Additional Auto Financing Tips

If you are considering an auto loan, here are a few other tips to keep in mind:

  • Take the appropriate steps to get out of debt as soon as you reasonably can.
  • Paying off your auto loan early may save you a significant amount of money.  However, keep in mind that some auto loans charge a small prepayment penalty.
  • Some people take out home equity loans to finance the purchase of an auto.  This will likely lower your rate and your interest may be deductible, but you risk losing your home if you default on the loan.
  • Many advisors recommend that your car payments, including fuel, insurance, and loan payments not exceed 20% of your disposable income.  Remember, this is the maximum, not the goal.
  • Create a budget to make sure you can afford your payments before taking out an auto loan.  Don’t let anyone else influence what you can and cannot afford.
  • Don’t feel that you have to spend the full amount a lender will lend you.  Just because you can afford a certain vehicle doesn’t mean you should purchase it. Make sure you understand any fees or potential penalties associated with a loan.
  • Try and pay off an old auto loan before you purchase another car.
  • Before taking out a traditional auto loan, see what rates you are offered at a peer to peer borrowing site such as Prosper.  I would use a peer to peer loan to purchase an auto in a heartbeat if it offered me a better deal than I could find elsewhere.

What are your thoughts about auto financing?  How do you ensure that you find the best deal on auto loans?  Leave a comment below!

Image: Sven Hoppe/Bigstock

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