All you need to know before you decide to finance a car purchase (Part I)

For the sake of this article and to ensure the information shared is as accurate as can be, I spent time with various bankers and car dealerships to understand how they structure their finance schemes. I will break it down step by step – the process of being pre-approved for a loan all the way to how insurance can play a big factor in determining your future car.

The main steps will remain the same, but the numbers can change person to person so do not expect for two people even with identical files to get the same deal on a car purchase – new or used.

Step 1: Get pre-qualified for a new auto-loan with a lender.

There are many sources of lending but it is always recommended to approach either a bank or credit union if interesting in financing a car purchase. This may include a local bank/union or one located elsewhere (maybe online options). A simple google search will land you several search results on what process is required by lenders to get pre-approved for loans.

In the case of a local branch – say Wells Fargo – you would be required to meet with a banker on the pretext you’re there to apply for a pre-approval offer for an auto-loan, share details such as your name, address, Social Security Number, income (in some cases) and based on those, they will pull your credit report. Keep in mind, this will be a hard pull so it will count as an inquiry in your file (affect your FICO credit score). No cost is involved in a pre-approval and if the lender states there is a charge, its best to avoid such a lender.

Additionally, prior long term relationships with the bank can improve your chances of getting approved and also get a discounted interest rate towards the loan. Factors affecting this can range anywhere from length of relationship, amount kept in the bank account consistently over time, diversification of accounts with the bank and no delinquencies or prior missed payments.

For example, a person with a 10 year relationship with a bank having kept $50,000 on average is more likely to get a much lower rate than someone with a year and $1000 on average. The auto department of the bank generally reviews this information and decides the rates.

Bankers may ask additional questions about net assets, your debt-to-income ratio (not to be confused with “debt-to-limit ratio” or “credit utilization”), money/equity you wish to put up towards initial payment on the car, liquid assets, income stubs, W-2 or income tax documents if you decide to proceed further in the loan process.

Step 2: Ensure you have an initial amount to pay upfront costs.

For those of you who have never bought a car, there generally are two charges that are paid to the government no matter the true value of the car – registration and license as well as tax. This amount collectively can be 6.25%-10% depending on the state you are purchasing/registering the vehicle. Some states have lower registration costs, but if your permanent residence is not the same state as registration, it might be an issue. The bank will direct you to have the car registered in the state of residence as well as pay the appropriate taxes.

Other upfront costs can be the documentation charges that the bank may have or dealership decide to include in the bill of sale – but such a charge can generally be negotiated off. Since the ownership of the car is a split ownership and a lien will be added with the Bank’s name, they will generally expect you to put the correct numbers and not lie to avoid taxation.

As an example, if you are financing a $30,000 car with a bank, expect to shell out at-least $3000 towards documentation if not higher (down-payment – negotiable amount).

A down-payment can in many cases improve the interest rate as well if you are purchasing a brand new car and finance directly with the dealership. Ideally, most down-payments are 10-20% of the base value of the car.

As a side note, I would like to state that taking a financing deal with the dealership is not necessarily a bad deal (most of the times). If they pre-approve you the same way a bank might and give you a 0% interest rate deal for lets say 60 months towards a $30,000 car – that is an amazing deal. (I will show how the numbers make a difference later on).

Step 3: Understand how banks value your vehicle. Don’t waste everyone’s time.

Most banks will look at KellyBlueBook retail value. (even if you buy from a private party, they will use retail value). When deciding what amount to borrow towards a loan, ensure you get the exact price including the trim, features, mileage (for used car) and add-on options for that particular vehicle. The bank might not approve you if you entered the details for a Toyota Corolla S but purchased an SE trim because the latter is more expensive and you’re borrowing more than what they think you can pay.

Most banks/credit unions can finance upto 100% of the retail KBB value to help with closing costs as well. If you have a lower credit score, they will be wiling to give you a loan of maybe 60-80% and you put in the rest of the equity. This is to minimize their risk on the underlying property – the vehicle.

If you are someone who has a lower credit score, or lower income, do not have expectations to get an amazing rate. As a rule of thumb, longer the loan period, lower the monthly payments but higher the interest.

The average US financing period is 68 months with an interest rate of 4.2% on a $30,000 new car purchase.

Step 4: DO math (what can you afford)

Bankers or financial analysts will sit down with you and run the numbers to go over what you can actually afford.

Example:

$10000 2.99% 60 mo = $179.64/mo

$15000 2.99% 60mo = $269.46/mo

$25000 2.99% 60mo = $359.28/mo

Lets go over the following examples (I pulled from the Wells Fargo auto-loan calculator)-

Note: Car cost: $30,000 (fixed); FICO score (BEST: 760+); Load duration: variable; Interest rate: Variable

Duration Interest Rate (APR) Estimated monthly payment

36 months 4.21% – 10.72% $889 – $979

48 months 4.16% – 10.66% $680 – $771

60 months 4.12% – 10.63% $555 – $647

72 months 4.10% – 10.61% $471 – $566

Do keep in mind, these are not the final representation of APR numbers or monthly payments. Prior relationships with the bank as well as a clean diversified and on-time payment history can reward you with better rates (as low as 0%). Why APR matters is because it is the additional interest you pay on a depreciating asset.

A car depreciates – the moment you drive off the lot you lose 10% of its value (if brand new). Over time, it will lose more an more value and the higher interest you pay on a depreciating asset, the stupider it sounds. This is why a good credit score and history matters. I constantly advise my readers to build a strong base which will some day help you potentially avoid $1000s in interest payments towards a car/house/rent.

If you have good credit, interest rates can vary from 0-4%. For excellent credit history, you can get a 0% rate and the worse the score, higher the interest and the more you pay every more month. Longer term payments can be riskier for the bank because they hold not just a depreciating asset. but they also would not otherwise make much money – hence the APR can rise. Shop around to get the best rates – the financing company could be one established in another country too – as long as you can get the paperwork through and keep making on-time payments, all is good.

Ideally, the longest period you should ever go for on a financing-term is 60 months – don’t go over it (to account for depreciation). The shorter the time frame the better even if it costs you more every month. At-least this way, you acquire full ownership of the car quicker and be done with it.

On average, a car can depreciate upto 40% in its first three years – more if it is an unreliable car known to has lots of problems. More reliable the car, higher the retention value. For example, a BMW M3 with a sticker price of $62,000 in 2009 will sell for maybe 10% of its original cost after 10 years while a Lexus IS F with a sticker price of $60,000 will sell for as high as 36% of its original cost – provided it has a clean service recorded history (CarFax).

Feel free to use various auto loan calculators and see what impact an auto loan on your credit score as well as monthly spend – plan for the future now!

I cover the remaining two steps in your car purchase journey here.