Auto Loans: Financing a Car With Bad Credit
Getting a loan to buy your next car can seem like a daunting task. There’s all this paperwork to fill out, you have to come up with a down-payment somehow, and then there’s a magic “credit score” number that seems to dictate how much you’ll end up paying. Worst of all, if you’re not familiar with the process, you could end up paying more than you have to. Applying for an auto loan doesn’t have to be a big mystery. Read on for the steps you should take when financing your next vehicle purchase.
1. Know Your Credit Scores Before You Apply
Since your credit rating is one of the most important factors when it comes to how much you’ll pay over the life of the loan, it makes sense that you should know what your credit is before applying and certainly prior to signing any paperwork. The easiest way to find out where your credit stands is to obtain a copy of your credit report. You can do this by visiting the free government website AnnualCreditReport.com, or by using any of the dozens of paid websites out there, many of which will give you your credit score (the actual number) in addition to your report.
Look through your credit report to make sure everything is accurate, and if your report includes your credit score, see what that number is. If you have a decent credit history, have made all your payments on time and don’t have any outstanding debt that you’re not paying on, you’ll be in good shape to get a more attractive rate on your loan. However, if you’ve missed payments here and there, or worse, have had a debt turned over to a collections agency, expect to pay more interest, or be rejected altogether if the lender doesn’t like what they see on your report.
2. Research the Rates for Financing and Look for Deals
Many banks will publish their current interest rates on their websites in order to attract customers. Since the interest rate determines how much interest you’ll pay on the loan, it’s worth the time to get an idea of what rates are being offered so you don’t get fooled by a higher rate when it comes time to sign the papers. Keep in mind that advertised interest rates usually assume that you have good or great credit, so you may end up paying a couple percentage points more if your credit is less than perfect.
Having an idea of what interest rate to expect will help you in the negotiating phase of the purchase as well. If the dealer is trying to offer you a rate that’s higher than what you know you can get from other places, you can use that as leverage to get them to lower it.
3. Decide on a Lender (Bank, Credit Union, or Dealer Financing)
This step can go one of two ways. Your first option for financing is to go through a regular bank, whether it be the bank that you have accounts with, or one that you don’t have a relationship with yet. The normal process is to apply for a loan through the bank, and they will give you a pre-approval letter saying that you’re approved for a loan up to a certain amount, so all you have to do is negotiate with the dealer on the final price of the vehicle. (This can be useful because a salesperson will sometimes try to focus on the amount of your monthly payments instead of the overall price of the vehicle.) Once you’ve settled on a price, go back to your bank to finish the paperwork and you’re all done. If a dealership has a partnership with your bank, they can sometimes close the deal then and there without requiring you to drive back to your bank.
The second option for financing is to go through the dealership, without any third-party banks. Each brand of vehicle has their own bank-of-sorts that you can get a loan through. This can be a valuable option because the dealership is usually able to offer you special deals or discounts that you couldn’t get if you didn’t finance through them. For example, the rebates and discounts that they talk about on their commercials are usually only available if you finance through the dealer. If you decide to take this route, keep in mind that your salesperson has a greater ability to play around with your monthly payments, loan term, and interest rate in order to distract you from the overall price that you’ll end up paying. Keep them honest and try to keep the discussion centered on the final price, not monthly payments.
Applying for and obtaining an auto loan doesn’t have to be a mystery. Know your credit beforehand, research the best interest rates, and figure out who you want to finance with, and you’ll be well-prepared when it comes time to sign the paperwork.
If you will be purchasing the car with a loan, be aware of your financing options. Consider options such as a home equity line of credit for potential tax deductions and a relatively low interest rate, or 401(k) loans for a guaranteed loan and a very competitive interest rate. Many banks, credit unions, and other financial institutions offer favorable interest rates on car loans. The dealer can often get you a loan, but you may be able to get better terms if you shop for financing before you choose your car.
This way, you will be able to evaluate the terms offered by the dealer and compare them to terms offered elsewhere. If the manufacturer offers a special financing deal on the car you choose, these will probably be the best terms available.
Be aware, that in order to take advantage of this low rate there may be special requirements or restrictions. For example, you may have to make a particularly large down payment.
Car Loan FAQ
Is it smart to use cash to buy a new car, or should I invest my cash and use a car loan instead? You’re buying a car for $20,000. You can either pay cash or borrow $20,000 at 9 percent interest for 48 months. Assume that if you borrow the money, you will invest your $20,000 and earn a 7 percent after-tax rate of return. Also assume that if you pay cash, you’ll invest the money you would otherwise have used to repay the loan each month. This investment will also earn a 7 percent after-tax rate of return.
If you borrow $20,000 at 9 percent interest for 48 months, your monthly payment will be $498. The total of your payments over the term of the loan will be $23,904. During this same time, your cash (invested at 7 percent after-tax) would grow to $26,216.
If you pay cash for the car instead, you would invest $498 per month instead of making payments on the car loan. In total, you would invest $23,904. Assuming a 7 percent after-tax rate of return, your investment would grow to $27,374 after 48 months.
In this example, paying cash was a better choice because the return on your investment was lower than the auto loan interest rate. If you can get a great interest rate, taking a loan and investing the cash will put you further ahead. The key to determining your best course of action lies in calculating the total cost of repaying the loan (or repaying yourself) and comparing this to the expected return on your investment.
Would you advise against borrowing from a friend or family member to purchase a car? Sometimes a family member will lend you money to buy a car, often with little or no interest charged. However, before taking a low or no-interest loan from a family member, it’s important to understand the potential tax implications. Interest-free and low-interest loans from a family member may have gift tax implications for the lender. In addition, the interest on a loan is considered taxable income to the person who lends the money. If no interest is charged or the rate is unusually low, the Internal Revenue Service may impute interest. This means that the lender must pay taxes as though interest is being paid at a fair rate. Loans of $10,000 or less generally aren’t subject to imputed interest. Some exceptions also apply to loans over $10,000, if the borrower’s net investment income is minimal. Since this calculation can be somewhat complex, you may wish to consult a tax professional in determining the income and gift tax consequences of an interest-free or low-interest loan. Number crunching, tax consequences, and that new car smell aside, consider the most important factor in this scenario: the personal relationship that could be put in jeopardy at any moment because of money. I always advise against lending or borrowing to/from friends/family for any purpose.
Can I use my home equity line of credit to purchase a car? Generally, you can use a home equity line of credit to purchase a car. An obvious advantage, particularly for those people who have bad credit, is that a secured line or loan like a heloc is much easier to get from a lender and the rates are much, much lower than traditional car loans and unsecured loans. Another advantage to this type of financing is that, because the loan is secured by your home, the interest is may be tax deductible (although you should consult a tax professional before taking a home equity loan for this purpose). The disadvantage is that if you don’t repay the loan as agreed, you could lose your home.
How about borrowing from my 401(k) or 403(b)? If you have sufficient funds in your employer-sponsored retirement plan, check with the plan administrator to determine whether you’re allowed a loan from the plan. Generally, plans allow loans from $500 up to $50,000 from your account. The percentage you’re allowed to borrow often varies from 50 percent to 80 percent of the plan value. The interest rates are usually similar to home equity loan rates, but the good news is that you’re paying yourself that interest. The bad news is: if the stock market increases tremendously while you have a loan outstanding, you miss out on the growth on that portion of the account balance that has been borrowed. There aren’t many people who would advise using your retirement savings to purchase a depreciable item, such as a car. Again, please seek the advice of a financial planner or a tax professional who can discuss the cost-benefit in more detail.
Caution: If you don’t repay the loan within five years or if you miss payments, the loan may be treated as a distribution for income tax purposes and thus may be included in your income and subject to the early withdrawal penalty. If you leave your employer, the loan could also be called due.