Part 1

With a slowdown in new car production that has resulted from the coronavirus pandemic, the used car market has seen a significant spike. According to Kelley Blue Book, the average price of a new car in January hit $40,587. Compare that to the used car average price of just over $21,000 and you can see why shoppers are jumping into the used car market.

Although the price of a used car is much less than a new car, the majority of car buyers do not have the cash on hand to fully pay for a used car. If buyers find themselves in this situation, the good news is there are plenty of great options available when it comes to purchasing a used car loan.

How Does a Used Car Loan 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 the borrower agrees 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 over which you will be responsible for repaying the loan. Often, loan terms will range from 36 to 84 months. The longer the loan term, the lower the monthly payment, however, a borrower will pay more overall in interest. According to Edmunds, the most common loan term today is 72 months.

Down Payment

The down payment is an initial upfront payment the borrower makes towards the vehicle. Lenders often require borrowers to make a down payment to decrease the risk for the lender. In addition, a down payment will decrease the amount financed by the buyer, saving the buyer money in overall interest paid.

Best Option for a Used Car Loan

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 works in the buyer’s favor when applying for a loan with less-than-perfect credit.

In addition, if looking to purchase a used car loan from a private party seller, the borrower will 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 a Used Car Loan

Borrowers can also get a used car loan straight from the dealer. This creates one-stop-shopping and convenience, but it may not always be the most cost-effective way to obtain a used car loan.

Captive Financing

Many car manufacturers own financing companies that make loans for both used cars and certified pre-owned cars. For example, Ford motor company has a finance arm called Ford Credit, which provides financing for new, used, and certified pre-owned Ford vehicles. The downside for a used car buyer is 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

Another option is known as dealer rate shopping. In this scenario, the buyer chooses the vehicle from the dealership and the dealer shops the best rate from multiple lenders on the buyer’s behalf. Keep in mind, 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

Some used car dealers are known as buy here pay here dealerships. These car dealers offer in-house financing and primarily have car buyers who have poor credit or no credit history. If you’re looking to get a used car loan with credit problems, this may be the best option. Keep in mind, there are higher fees and interest rates when choosing to go with buy here pay here financing. A better option may be to clean up your credit and apply for a used car loan elsewhere.

Part 2

7 Steps to Getting a Used Car Loan

Now that you understand your options for securing a used car loan, let’s break down the step-by-step process to streamline your used car loan experience.

1. Check Your Credit Score

Before you start your used car search, it’s helpful to have a general awareness of your credit score. You can get this information for free through most credit card companies. If you don’t have a credit card or your credit card doesn’t offer credit score monitoring, sites like Credit Sesame and Credit Karma will provide free credit score information.

You should also check your full credit report for accuracy at least once per year. AnnualCreditReport.com will give you a free copy of your credit report for each of the three credit bureaus once per year.

Your credit score has a significant impact on the interest rate you may receive for a used car loan.

Credit Score Average Used Car Rate
Deep Subprime (579 and below) 20.45%
Subprime (580 - 619) 17.74%
Nonprime (620-659) 11.26%
Prime (660 - 719) 6.04%
Superprime (720 and above) 4.29%

Source: Experian.com

2. Shop Around for Rates and Deals

Once you know your score and have a good idea of the rate you can expect, the next step is to shop around for the best deal. Remember, you can compare rates and terms with large banks, local banks, credit unions, and through dealership financing.

Not only does the rate have an impact on your monthly payment, it also impacts the total interest you will pay for the life of the loan. For example, a $25,000 loan on a 60-month term at 3% APR will have a total interest amount of $1,953. Compare that with a 7% interest rate and you will pay a total of $4,700 in interest.

3. Getting Pre-Approved

It’s a great idea to get pre-approved through a lender such as a bank or credit union. Once pre-approved, you essentially become a cash buyer at the dealership. This allows you to skip any hassle, price-markups, or creative financing options through the dealership.

It’s also important to realize the difference between pre-approval and pre-qualification. Pre approval means the lender has already reviewed your credit report and approved your interest rate. Pre-qualification takes into consideration your credit score, which means your approved rate may be higher after reviewing your entire credit report. In either case, your rate may adjust slightly depending on the make, model, and year of the car you choose.

Pre-approval Pre-qualification
Credit: Hard pull on your credit Credit: Soft pull on your credit
Rate: Approved rate before you buy Rate: Can fluctuate after full credit check (hard pull on your credit)
Perk: You become a cash buyer at the dealership instead of working through the dealership finance department Perk: None

When getting pre-approved, the lender will do a hard pull on your credit, which results in an initial decrease on your credit score. However, when multiple lenders do a hard pull within a 14-day period, credit reporting agencies view this as only one hard pull on your credit.

4. Set Your Budget

Keep in mind that the amount you are pre-approved for and the amount your budget will allow are two different numbers. The most important factor is to determine what your monthly budget can afford in terms of adding another monthly payment.

To determine the monthly payment based on the used car purchase, use an auto loan calculator. Simply enter in the price of the car you’re looking to purchase, the down payment, length of the loan, and the interest rate to determine the monthly payment.

Lastly, remember when you extend the term of the loan, the monthly payment will decrease but the overall interest you will pay over the loan also increases. For example, a $25,000 loan at 3% for 60 months totals $1,953 in interest with a monthly payment of $450. If you choose to extend the loan another year to 72 months, the monthly payment decreases to $380, but the total interest you pay increases to $2,348.

5. Research Potential Cars

Once you are pre-approved and you’ve determined the monthly payment you can afford, now is the time to start researching potential cars. For example, let’s assume you can afford a monthly payment up to $450. Using an auto loan calculator, you’ve decided to finance a used car over 60 months with an interest rate of 3%. This allows you to purchase a vehicle in the $25,000 or below range.

Now the fun begins, and you can begin looking for a used car within your purchase limit amount.

Money Tip: Most lenders will give you 30 days to shop around for your vehicle after pre-approval.

6. Buying from a Private Party Seller

If you decide to purchase from a private party instead of a dealership, you will want to work with a local bank or credit union. The first thing you need to provide to your lender is a vehicle history report. The lender may offer this service to you as a perk. You can also use services such as Carfax and Autocheck.

Important: If the seller still has a loan on the vehicle, the seller will be required to pay off the loan prior to the lender approving the loan. Once the lienholder has been removed from the seller's title, the lender will move forward with the loan.

With a clean title in hand, the seller will provide your lender with the title and the lender will pay the seller on your behalf. Most often, lenders will cut a check directly to the seller or will wire funds directly to the seller’s bank account.

7. Finalize the Purchase and Drive Away

The last step is to finalize the purchase of the vehicle and complete the loan agreement. This includes having full insurance coverage on the vehicle.

From this point forward, the most important thing you can do with your used car loan is to make on-time payments. Payment history makes up the largest portion of your credit score and even one missed payment will remain on your credit report for seven years.

Summary

Purchasing a used car may be a great way for you to drive a reliable car 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 are 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.

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.