Spending

This big auto loan mistake could cost you thousands of dollars when you're buying a car

“It’s extremely important to do your shopping ahead of time.”

Share
Twenty/20

If you're shopping for a car and plan to purchase it with an auto loan, you'll want to explore your financing options before heading to the lot. Otherwise, you could end up getting a bad rate that costs you more money in the long run.

Here's how experts suggest you avoid that common, and often expensive, mistake when buying a car.

Check your credit score first

A significant factor that determines your monthly car loan payment is your credit score. For example, if you have an excellent score and want to spend $15,000 on a used car with a 20% down payment, Wells Fargo offers a 72-month loan with a 4% APR and monthly payments of $236, according to new data from WalletHub. Capital One offers one with the same length of time to pay it back at 5% APR and monthly payments of $244.

"A good credit score is absolutely critical to getting the best rate," says Matt DeLorenzo, the senior managing editor at Kelley Blue Book, since it determines your risk to lenders. "The lower the score, the greater the risk."

VIDEO4:5704:57
How to avoid common auto loan mistakes

Video by Jason Armesto

If your credit is poor, or below 580, you may have a hard time finding an affordable loan, if you can secure one at all. The current average rate on auto loans for people with poor credit is more than 17% on both new and used cars, according to data from U.S. News and MyAutoLoan.

So to compare, if you have great credit and buy a car for $15,000, with a 20% down payment and 4% APR on a 72-month loan, your total interest over the life of the loan will be $1,517, according to FICO's auto loan calculator. If you buy the same car with the same down payment, but end up with an 84-month loan and 17% APR because of poor credit, you'll pay about $8,599 in interest. That's a difference of $7,082.

About 90% of car loan lenders use your FICO auto score, credit expert Gerri Detweiler previously told Grow. This score takes your credit history into account to evaluate the likelihood you'll pay back the loan.

You can pay to check your FICO auto score, which ranges from 250 to 900, but it isn't usually necessary since your regular FICO score can be an indicator of what lenders may offer you.

Your best option is to increase your credit score, DeLorenzo says: "You may want to look online to find ways to bump up that number. It will pay off in lower monthly loan payments."

Improving your credit utilization rate, which is the ratio of your outstanding balances versus your total credit limit, can improve your overall credit. Experts suggest trying to stay under 30%. Also, be sure to pay your balance on time and in full as late payments can ding your score.

VIDEO2:5002:50
How to improve your credit score in 4 steps

Video by Stephen Parkhurst

Shop around for the best loan

Whether you're buying new or used, you can get an auto loan from your vehicle manufacturer, from a traditional bank, like PNC, or another third-party financial institution. The rate you get on that loan will vary widely based on which source and style of loan you choose, but many shoppers don't know this when they walk into the dealership.

If you have an excellent credit score, above 800, Capital One Bank might give you a $374 monthly payment on a 60-month term. But if you went with a credit union like PenFed, you would pay $366 per month.

Many auto loans are secured, meaning they are guaranteed by a lien on the vehicle. There are also unsecured loans, which are less common, and not secured by an underlying asset. The catch is that these types of loans have higher interest rates to cover for greater risk.

Buyers can also apply for simple-interest loans, which accrue interest on a regular basis and allow borrowers to accelerate their payoff time and limit interest by making larger or additional payments. Title loans, on the other hand, allow drivers to borrow directly against the value of their car and take possession of the title. The lender, however, retains the right to repossess the car if the loan becomes delinquent.

The method you use to repay will depend on the type of loan you get. That's why it makes sense to check out your financing options before you visit the dealership so you will be better prepared to select the best choice or negotiate a deal if you need to.    

VIDEO4:1604:16
How this couple saved $1,500 buying a new car during the pandemic

Video by Stephen Parkhurst

"It's always a smart move to shop around for outside financing before going to a car dealership," says Karl Brauer, executive analyst at iSeeCars.com. This shows you're a serious and informed buyer, and can provide you with a bargaining tool for a better rate. "Because dealers make more money on vehicles they finance, they will probably try and beat your outside rate," he says. "If you don't shop around, you might think that the dealer is providing an attractive rate, when it's actually higher than what you should be paying."

Having a preapproved loan in your back pocket from a local bank or credit union is a great negotiating tool, says DeLorenzo. "Dealers also have access to financing through lending institutions and captive finance arms of their respective manufacturers. See if they can beat the rate you walk in the door with."

Keep loan length in mind

The average car loan is about 72 months, according to Edmunds, but the sooner you can pay that off, the better, Lauren Fix, a sector analyst at auto news and education website Car Coach Reports, recently told Grow: "I do not recommend anything longer than a five-year loan or a three-year lease. After that, you're leaving money on the table and it's a bad financial move."

Plus, a shorter loan length means more time between big purchases where you have no monthly auto payment, helping you put any extra cash toward other financial goals.

As car prices continue to rise during the pandemic, however, longer loans are becoming more common. "We are seeing longer six, seven, or even eight-year loans to keep monthly payments manageable," says DeLorenzo. But be careful: "Even if you have a lower monthly payment, over the long term, you'll pay more in the additional interest payments over the life of the loan. You also risk getting 'upside down,' where you owe more on the vehicle than its market value."

If you don't shop around, you might think that the dealer is providing an attractive rate, when it's actually higher than what you should be paying.
Karl Brauer
executive analyst, iSeeCars.com

If you can only afford the monthly payments of a longer loan, you may want to consider a more affordable vehicle or looking at a used model rather than a brand new one.

Don't feel too bad if you currently have a loan you don't like, though. It isn't too late to reassess. One potential solution is to refinance, which can be especially helpful if your credit has improved since or rates have dropped since you originally took out the loan.

A 2020 WalletHub auto financing report found that buyers who have fair credit will end up spending about four times more to finance a vehicle than someone with excellent credit. To put that in perspective, that equates to $6,031 in additional interest payments over the life of a $20,000, five-year loan.

If you do choose to refinance, experts suggest keeping your current term rather than extending repayment, in order to reduce the overall amount of interest you pay.

Look at the full financial picture

It's important to treat a car purchase like any other financial goal, by planning ahead and doing your homework. Websites like Edmunds and Kelley Blue Book can help you crunch the numbers. And Bankrate's Lease vs. Buy calculator can also help you determine the most cost-effective way to go.

"Do your research in advance by looking at reviews, Car Coach Reports, Kelley Blue Book, and others that are good resources," says Fix. "Third-party experts will always give you a different perspective because they're not trying to sell you, they're just trying to educate and inform."

Choosing the best route for you will ultimately come down to your lifestyle and how you handle money. But you should always plan for the long term and let your budget be the driving factor.

More from Grow: