The Complete Auto Loan Guide

Buying a car isn’t something you do overnight. It’s one of the largest purchases you will ever make, and a lot of research goes into choosing the right automobile. But getting the right car is only one major concern. Paying for it is another. If you’re like most Canadians, you don’t have enough cash to buy a new car outright, or even a good used one.

That’s where an auto loan comes in.

From interest rates to down payments, our experts will ensure you understand all the conditions of your car loan.

Especially if you are a first-time car buyer, the prospect of financing your purchase with a loan may seem overwhelming. But it’s much more doable once you understand the basics. Today’s primer will help you understand those basics before you take out a loan for your next set of wheels.

What Is a Car Loan?

A car loan works much like other kinds of loan. You take out a car loan through a bank or credit union to pay the car dealership, and you agree to repay the amount borrowed, plus interest, in monthly installments.

The amount of money you borrow, your interest rate, and the time you take to repay all affect the size of your monthly payment and the total amount due.

• Loan amount. The loan amount may be significantly less than the value of your car if you have a vehicle to trade in or you are making a down payment.
• The annual percentage rate (APR). The APR is the cost you pay every year, typically expressed as a percentage, to take out the loan,
• Loan term. This is the length of time you have to repay the loan, usually 36 to 72 months.

The prospect of lower monthly payments may seem appealing in the short run, but we recommend that you look at the grand scheme of things. A significantly lower monthly payment also means that you will end up paying a lot more for your car over the life of the loan than you would if you accept higher monthly payments.

Your lender’s auto-loan calculator can help you figure out how different loan amounts, APRs, and loan terms affect your monthly payment. Understanding these aspects of a car loan will help you negotiate the best deal on an auto loan.

Auto Financing Tips

Before you approach a lender for a loan, do some advance planning to make sure that the process goes as smoothly as possible and that you get the best possible bargain. This means thinking about a budget, checking and maybe improving your credit score, understanding how the size of your down payment affects the size and number of your payments on the loan, and keeping the loan as unencumbered as possible.

Prepare a budget

Before you start shopping for a car, determine how much you can comfortably afford to spend. A long-term loan that seems affordable may in fact be beyond your budget. Having a detailed and explicit budget gives you a better chance of securing a loan that you can repay on time. Here are the aspects of a loan that your budget must take into account:

• Down payment. The down payment is the amount of money you pay up front when buying a car. Generally, the larger the down payment, the smaller the amount of the loan and the smaller or fewer the monthly payments. To secure favourable loan terms, make a down payment of at least 20 percent of the buying price. If you have a car to trade in, the trade-in credit will cover part of the down payment and perhaps even all of it.
• Monthly payments. These are payments of the same amount each month for a specified period. Preparing a detailed budget can help keep your monthly payments at a comfortable level so that you can keep making them even if something happens to reduce your income.
• Loan term. The loan term is the length of time during which you are repaying the loan. Although a longer term—say, more than 72 months—gives you the benefit of lower monthly payments, it can increase the interest costs and total costs over the life of your loan. A shorter-term loan that reduces the interest and total loan costs is preferable, but only if you can afford it.
• APR. The annual percentage rate is the annualized interest rate that you will pay on the car loan. A lower APR means lower interest costs.

Your budget should take into account both the cost of the loan and the other costs associated with car ownership.

• Extra costs at the time of purchase: dealer fees, title fees, and taxes.
• Ongoing costs of ownership: insurance, maintenance and repairs, gas.

If it’s hard to put together a budget that meets all of your needs given your income, think about ways to reduce the cost of the loan. Possibilities include buying a cheaper car, saving for a larger down payment, and getting fewer add-ons like credit insurance, service contracts, and extended warranties.

Understand your credit score before you go to the dealership

Your credit score reflects your history of borrowing and indicates whether you have repaid any previous loans on time. It’s important to review and understand your credit score before visiting a dealership. Your credit score can be crucial in determining whether you are approved for the loan and, if you are approved, what its interest rate will be.

Most lenders will approve a lower interest rate for you if you have a good credit history. A lower interest rate means lower monthly payments and a lower total interest cost. You can request one free copy of your credit report per year from each of the two major credit reporting agencies.

Lenders look for evidence that you have managed your debt well so far and are likely to pay your new car loan on time and in full. Any blemishes in your credit file will raise a red flag, so be ready to explain such blemishes. Loans with the best terms and lowest interest rates are difficult to secure if you have negative items in your credit history.

If your credit isn’t perfect, get financing quotes before you go

A good credit score will almost certainly land you the best auto financing rates and terms, but what if you have less-than-stellar credit? Does it mean the end of the road for your ambition of owning a car? Not necessarily. You still have one last card to play.

Shopping around for different financing quotes is one of the best moves you can make. Different lenders have different eligibility terms and requirements, but online lenders can help you jump the first hurdle. By filling out a loan application online, you can receive an interest rate in minutes. The trick is to score decent terms for a loan that you can then use to bargain for better terms from a bank or other financial institution.

You should also consider getting preapproved before heading out to purchase your car. Most banks and other lending institutions let you get preapproved before you even enter a dealership. This short and often online process may help you get financing for less than what your dealer would arrange with his lending partners.

Getting several financing quotes may help you land better rates and terms even when your credit score is less than perfect.

How the down payment affects your loan

Should you make a down payment on your car? Although you can buy a car with no down payment, it is usually not a good idea if you’re financing your purchase.

The size of your down payment can affect the interest rate of your loan, the size of the monthly car payment, and the term of repayment. The down payment may include cash, the trade-in value of your current vehicle, or a combination of both. When buying a new car, always try to cover at least 20 percent of the purchase price of a new. A 10 percent down payment on a used car may be okay.

A larger down payment provides several benefits.

• Lower monthly payments. A larger down payment reduces the size of your loan. That means you need to pay less each month as you repay the loan.
• Shorter loan term. A larger down payment will help you avoid stretching out your car loan over an extended period for the sake of reducing monthly costs. For example, with a larger down payment, you may be able to choose a 48-month loan term rather than a 72-month loan term. All other things being equal, a shorter loan term is better, since it means that you get out of debt faster.
• Lower total interest payment. Since a larger down payment reduces the term of the loan, you will pay less in interest charges over the course of that term.

To be sure, you don’t want to stretch your finances too thin in order to put down more money for your car purchase. A 20 percent down payment makes sense if you’re not strapped for cash. But if you are strapped for cash, make as large a down payment as your finances permit.

Pay for taxes, fees, and extras with cash

Smart auto financing isn’t all about scoring the best interest rates and loan terms, it’s also about skipping add-ons that may require an unnecessarily large loan. Think about these extras ahead of time so that you know what add-ons you actually want on the day you finance your car. Most of these products and services are optional and negotiable. But factoring them into your purchase will only add to the total cost of your loan; if you must pay for them, use cash. Some of the common extras include:

• Extended warranties and service contracts. These agreements provide protection for repair costs on certain components of your vehicle.
• Guaranteed auto protection (GAP) insurance. If your vehicle is lost or destroyed, GAP insurance covers the difference between the value of the vehicle and what you still owe on your loan.
• Credit insurance. This insurance takes over your car loan payments in certain situations, like death or loss of employment.

Lenders may try to entice you with such extras, so stand your ground if you deem certain ones to be unnecessary. If you do need one or more of them, try to secure better rates.

Conclusion and Recommendation

Like automobiles, auto loans come in various shapes and sizes. Some are better bargains than others. Start the auto financing process by checking your credit score and fixing it if necessary. When you’re ready to go for a loan, don’t limit yourself to a single source of financing. Comparison shopping will help you get several nonbinding pre-approvals on a loan, one or more of which may offer a better interest rate than other lenders are offering.

Play it safe with an auto loan. Stretching the term of your loan will lower your monthly payments, but keeping it shorter will give interest less time to accrue, reducing your total loan costs. If you can’t comfortably swing the monthly payment on a 48-month loan or 60-month loan for the car you want, consider switching to a lower-priced vehicle. Remember that if you don’t keep up with your monthly payments, your lender may repossess your vehicle.

Frequently Asked Questions

Which is better: personal loans or car loans?

You can take out either a personal loan or an auto loan when buying a vehicle. Car loans tend to be less expensive. Auto loans typically have APRs in the range of 3 percent to 7 percent; personal loans typically have an interest rate in the range of 6 percent to 30 percent. You can use a personal loan for just about anything, whereas an auto loan is used exclusively for buying a car. Most personal loans are unsecured. Car loans use the vehicle that you are buying as collateral, which reduces the lender’s risk and therefore the interest rate that you need to pay.

The average size of a personal loan is about $11,000; the average size of an auto loan for a new car is $32,000. So if you do try to obtain a personal loan to buy a car, you may not be able to obtain enough money to do so by this method. Individuals with bad credit can often access both personal and auto loans. But it’s a bit easier to get an auto loan with bad credit since the lender has the power to repossess the vehicle if you don’t keep up your payments.

How does a car loan affect your car insurance?

Financing your car purchase may affect the requirements for your insurance coverage. Lenders often require that you carry both comprehensive and collision coverage in addition to the minimum car insurance that the law requires. Also, having a car loan may have the implication of carrying insurance policies that allow for lower deductibles, which translates into a more expensive premium.

Once you’ve paid off the auto loan, the financing institution no longer has a say about what insurance coverage you must carry. You can then consider different options.

Which is better: zero percent APR or a cash rebate?

Many car dealers offer a rebate instead of a zero percent APR. A cash rebate has no strings attached, whereas you need a stellar credit history to qualify for zero percent financing. A zero percent APR may be a better deal if you want lower monthly payments. A cash rebate will reduce your auto loan balance. If you are in the fortunate position of being able to choose between them, which alternative is better comes down to crunching the numbers. An online auto loan calculator can help you determine which would save you more.