What We'll Cover
- The three main parts of an auto loan are the interest rate, the loan term and the down payment.
- Your credit score has a significant impact on the interest rate you may receive for a used car loan.
- Most lenders will give you 30 days to shop around for your vehicle after pre-approval.
- The most important thing to do with your used car loan is to make on-time payments.
While new cars come with all their shiny bells and whistles, they also come with a high price tag. The price point is where used cars look much more attractive. Even though used cars cost a much lower price than a new car, it’s still not always feasible to pay for it in full.
Financing a used car can help you purchase a reliable vehicle that fits inside your monthly budget. Let’s dive into how to finance a used car, how auto loans work and best practices obtaining a car loan.
How Does Financing a Used Car Work?
Before applying for a used car loan, it’s helpful to understand the components of the loan. The three main parts of the loan are the interest rate, the loan term and the down payment.
Interest Rate
The interest rate is the amount of interest you agree to pay for borrowing on the loan. The rate is expressed as an annual percentage. For example, a 3% interest rate represents 3% interest per year on the amount financed.
Loan Term
The loan term is the number of months you’ll be responsible for repaying the loan. Loan terms range from 36 to 84 months. The longer the loan term, the lower the monthly payment - however, you will pay more overall in interest with a longer loan term. According to Edmunds, the most common loan term today is 72 months.
Down Payment
The down payment is an initial upfront payment you make towards the vehicle. Lenders often require borrowers to make a down payment to decrease the risk for the lender. In addition, a down payment decreases the amount financed by the buyer, saving the buyer money in overall interest paid.
Is It a Good Idea to Finance a Used Car?
Financing a used car is common among car buyers because there are many upsides to it. But as with all financial decisions, whether it’s the right move for you depends on a number of factors. Here are a few pros and cons to financing a used car, so you can determine whether it’s a good idea for your unique situation.
Pros of Financing a Used Car
- It’s easy to get a reasonable rate: No matter your credit score, getting a reasonable ARP on a used car is easy to do. Financial institutions can repossess the car if payments aren’t made, so their risk is reduced.
- Low down payment and up-front cost: Most used cars can be purchased with only 10%-20% of the value of the car.
- It helps build your credit: If you make payments on time, an auto loan can greatly help you build or improve your credit score.
- Financing allows you to buy a better car: If you pay in full for a car, you may be restricted to a smaller budget. But if you finance, you can likely afford to buy a better car that will last longer and potentially be safer.
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Cons of Financing a Used Car
- You pay more over time: Financing a car will cost you more in interest over the months than it would cost you to pay in full right away.
- You’ll have a monthly payment: An auto loan needs to be factored into your budget. This monthly payment adds to your debt. If you’re already struggling to make debt payments, then taking out a loan may not be in your best interest.
- You don’t own your car until it’s paid off: The lender holds the title to your car until you pay it off. They can repossess your car if you don’t make payments.
Best Option for a Used Auto Loan in Arizona
One of the best options for obtaining a used car loan is to go through a local bank or credit union. Local banks and credit unions are community-focused and take a more personal approach. This also works in your favor if you’re applying for a loan with less-than-perfect credit.
If you’re looking to purchase a used car loan from a private party seller, you need to use an outside financial institution. Local banks and credit unions are the best option for loan approval when purchasing a used car from a private party.
Lastly, credit unions frequently have the most competitive interest rates. This is because banks are for-profit and must create a profit for their shareholders. Credit unions on the other hand are nonprofit organizations owned by their members. Since credit unions do not have to generate a profit for their shareholders, they pass on the savings to their members in the form of lower loan rates.
Other Options for Obtaining a Used Car Loan
You can also get a used car loan right from the dealer. While this is convenient, it’s not always the most cost-effective way to finance a used car. Here are some options you might come across when car shopping:
- Captive financing: Many car manufacturers own financing companies that make loans for both used cars and certified pre-owned cars. However, the best rates are often reserved for new cars (such as 0% APR) and loans may be limited to certain makes and models.
- Dealer rate shopping: When you buy the vehicle from the dealership, the dealer shops the best rate from multiple lenders on the buyer’s behalf. Side note: this is rarely done as a courtesy to the buyer and often has a rate markup for the dealer to arrange the loan on the buyer’s behalf.
- Buy Here Pay Here financing: These car dealers offer in-house financing and primarily have car buyers who have poor credit or no credit history. While this might seem intriguing if you have poor credit, there are often higher fees and interest rates associated with this financing. A better option may be to clean up your credit and apply for a used car loan elsewhere.
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6 Steps to Getting Financing for a Used Car
- Check your credit score.
- Determine how much you can afford.
- Research the car you want.
- Research lenders.
- Apply for the used auto loan.
- Buy the car.
Now that you understand your options for securing a used car loan, let’s break down the step-by-step process on how to finance a used car.
Step 1: Check your credit score.
Before you start shopping for your next used car, the first thing you need to do is pull your credit report and check your credit score.
In fact, you are legally entitled to one free credit report from each of the three credit bureaus (Equifax, Experian, and TransUnion). To get your free credit report, head on over to AnnualCreditReport.com.
Look over your credit report and check for any errors. A Consumer Reports study actually found that nearly a third of Americans found errors on their credit report. Therefore, locating any errors and then fixing them is important before applying for your next used auto loan.
The details in your credit report will affect your credit score, and your credit score will determine your interest rate on your used auto loan. Below is a recent Experian report showing the relationships between your credit score and the average interest rates for used auto loans.
| Credit Score | Average APR for Used Auto Loan |
|---|---|
| Superprime (720 or above) | 4.29% |
| Prime (660 - 719) | 6.04% |
| Nonprime (620 - 659) | 11.26% |
| Subprime (580 - 619) | 17.74% |
| Deep Subprime (579 or below) | 20.45% |
Source: Experian
Let’s assume you’re looking to finance a used car for $20,000 over the next 5 years. If you have a credit score of 600, then you will pay an additional $7,080 in interest versus having a credit score of 700!
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Step 2: Determine how much you can afford.
Once you determine your credit score and have a good idea of your interest rate, it’s time to determine how much car actually fits inside your monthly budget.
A good rule of thumb is to keep your monthly auto payment at 10% or less of your monthly take-home pay. For example, if your take-home pay is $4,000 each month, then you should keep your total monthly auto payment at $400 or less.
Keep in mind, lenders will lower your monthly payment by extending your loan term. This may look good on the surface, but this will also cause you to pay more money over the entire term of the loan.
Another good practice is to keep the total cost of the vehicle, including interest, at 35% or less of your annual income.
For example, a $20,000 used auto loan at 6.04% interest over 5 years will have a monthly payment of $387. After five years, the total cost of the used car, including interest, is $23,221.
Using the 35% rule, an annual income of $66,000 would make this used car affordable using the rules mentioned above.
However, if the interest rate jumps to 11.26%, then the length of the loan would need to jump from five to six years to remain within the 10% rule of your take-home pay. This also causes the total cost of the used car to jump to $27,601, meaning you would need an annual income of $79,000 to afford the car.
Related calculator:
Use our Auto Loan Calculator to determine how much you can afford.
Step 3: Research the car you want.
After looking over your credit report and determining how much you can actually afford, it’s time to start researching the car you want.
When searching sites like Kelley Blue Book or J.D. Power, filter your searches to only show the vehicles that fit within your price range. Also, keep in mind the value of the used car does not necessarily equal the selling price for cars — especially in today’s car market.
Once you know the make, model, and year of the car you would like to buy, take it a step further and research what Consumer Reports says about the vehicle. It’s also a great idea to research comparable makes and models of the vehicle you have in mind to determine if there is something else that may be a better fit for both you and your wallet.
Step 4: Research lenders.
One common misconception when financing a used car is that all lenders are the same. Typically when shopping around for lenders, you will find the lowest rates and best loan terms from local banks and credit unions when compared to larger national banks or financing at the dealership.
Look for things such as the interest rate, the length of the loan term, and current promotions.
Another perk of working with a local bank or credit union is the ability to sit down face-to-face with a lender and have a conversation about your individual financial needs.
Unlike the very large national banks where you are just a customer, when you apply for a loan at your local credit union, you are a member. Since credit unions aren’t owned by investors and are instead owned by you, the member, they can offer lower rates and better terms for your next loan.
Step 5: Apply for the used auto loan.
Once you have chosen your lender, the next step is applying to be pre-approved. When choosing between a pre-qualification and pre-approval, always go with getting pre-approved before attempting to purchase the used car.
Pre-Approval vs. Pre-Qualified
| Pre-Approval | Pre-Qualified | |
|---|---|---|
| Definition | The lender has reviewed your credit report, credit score, and other information to determine the loan amount and rate you’re likely to receive. | The lender issues a loan at a rate within a wide range based on the limited personal and financial information. |
| Effect on Credit | Hard pull on credit | Soft pull on credit |
| Firm or Estimate | Firm loan offer from lender | Just an estimation on how much you will be approved for |
| Interest Rate | Interest rate is likely set | Interest rate is subject to change |
As you can see, getting pre-approved is better for both you and the seller. Pre-approval gives you terms and rates up front so you can determine how much you can actually afford. Pre-approval gives the seller the confidence that you’re a serious buyer who has already gone through the process of securing financing before making your offer.
Step 6: Buy the car.
If this is your first time buying a used car, you may be wondering how purchasing a used car works, especially if there is a current lien on the vehicle.
With a Lien on the Car
If you’re purchasing a used car from a private party seller, it’s important to check the title status of the vehicle.
Common liens could be a car financing loan, a car title loan, or a mechanic’s lien. Before you purchase the vehicle, you can search title records on most state motor vehicle websites.
If the vehicle does have a lien, then you should notify your lender and the lender will take the necessary steps to pay off the lienholder first and send the remaining balance (if any) to the seller.
Without a Lien
If there isn’t a lien on the vehicle, you should make sure the seller has the vehicle title in hand. If the seller does not have the title in hand, they will need to request a copy of the title in order to transfer the title to you once you purchase the vehicle.
After purchasing the vehicle, make sure the seller signs the title and transfers the title into your name. You can do this in person, through the mail, or online depending on your state’s policy.
Pro tip: Live in Arizona? You can transfer the title of a vehicle in-person, through the mail, or online here.
Financing for a Used Car Frequently Asked Questions
What is a good credit score for a used car loan?
There’s no set credit score needed to be approved for a used car loan, however, a higher score can get you a lower interest rate and better terms on your loan. Lenders use your credit score to determine how likely you are to repay the auto loan. The higher your credit score, the less of a risk you are to the lender. This is why they can give you a better rate.
What is the disadvantage of getting a loan for a used car?
The disadvantage to financing a used car versus paying in full up front is that you’ll pay more over time in interest, you take on a monthly payment, and you don’t actually own the vehicle until you’ve paid it off.
Does financing a used car build credit?
Yes, financing a used car can build credit. If you make payments on time, an auto loan will help build your credit score.
Key Takeaways
- The three main parts of an auto loan are the interest rate, the loan term and the down payment.
- Your credit score has a significant impact on the interest rate you may receive for a used car loan.
- Most lenders will give you 30 days to shop around for your vehicle after pre-approval.
- The most important thing to do with your used car loan is to make on-time payments.
Purchasing a used car may be a great way for you to drive a reliable vehicle for a price that fits inside your monthly budget. The most hassle-free and affordable way to obtain a used car loan will be through a local bank or credit union. However, if you’re looking for one-stop shopping and you don’t mind paying a little extra, financing directly with the dealership is another option.
Whichever route you choose, do your research and gather as much information as you can before you purchase your “new” used car.
By Chris “Peach” Petrie,
Founder of Money Peach
Chris “Peach” Petrie is the founder of Money Peach. Money Peach partnered with OneAZ to provide free financial education to members across the state. To learn more about OneAZ’s partnership with Money Peach, click here.
APR = Annual Percentage Rate
