A car loan is a personal loan that involves using the purchased car as security against the loan. In other words, a lender gives a borrower money to purchase the car they want.
Many individuals need a car to go to work and support their daily lifestyle. If you’re among these individuals, you’re likely looking for the cheapest, most economical way to get a car. Afterall, you want to get where you need to be at a reasonable price!
Generally speaking, you have three options: purchase a car with cash, lease a car or finance a car. Given how expensive cars are to purchase outright, most opt for a car lease or car loan. In this article, we will explore everything you need to know about car loans in comparison to car leases.
A car loan is a personal loan that involves using the purchased car as security against the loan. In other words, a lender gives a borrower money to purchase the car they want. In the event that the borrower stops making payments towards the loan, the car can be repossessed by the lender and sold to cover the cost of the owed loan. Once the car is purchased, the borrower must make payments to the lender including principal and interest payments.
When you’ve picked the car you want and are ready to obtain financing, the car loan application process begins. You can obtain financing from banks or other traditional lenders, credit unions, dealerships or online, alternative lenders. In your application for car financing, you will need to provide some basic personal and financial information. You will likely need to provide backup documentation to support the information you provided as well. Examples of information you need to provide include employment status and income, banking information and a driver’s license. Lenders tend to provide their requirements for financing to you ahead of time, be sure to ask what information and documentation they need so you can prepare accordingly.
Once your application is submitted, you will find out if you qualify for the loan. Depending on the lender, you could find out instantly or have to wait as long as a few weeks. You may need to reach out to a few lenders before obtaining financing, try to keep an open mind. Researching lenders and their requirements before applying can help ensure that you will qualify immediately and find the right fit. After you obtain financing, drive your car off the lot and start making payments!
As with all financial options, there is always an accompanying set of advantages and disadvantages. Car loans are no exception, let’s explore the corresponding pros and cons below.
Advantages
Disadvantages
Unfortunately, when financing a car, more work is involved than merely picking a car you like. You need to consider other things in your decision, such as loan conditions and affordability. Below are numerous items to consider when shopping for cars.
Budget & Affordability
Car purchases are an expense, not an investment. For this reason, you shouldn’t spend an unreasonable amount of money on a car because you will never get that money back. This is where your budget comes into play. Before buying a car, be sure to consider how much you can realistically afford.
Loan Term
The loan term is the length of time you will be making payments. In general, car loan terms are between two and eight years. The tradeoff here is that longer loan terms mean lower payments. But, the longer your term, the longer you will have the burden of the expense on your hands.
There is also a risk of negative equity when your loan term is long. Cars lose value rapidly which could lead to you owing more money than what the car is worth. When a car is worth less than what is owed against the car, the difference is known as negative equity. The longer your loan term is, the more likely it is that you’ll earn negative equity. For this reason, try to keep your loan term around five years or less.
Interest
The cost of financing is interest, there is no exception with car loans. Naturally, everyone wants to pay less interest, so they get the best deal on the money they’re borrowing. The lower the interest rate, the better!
Principal
The principal is the amount of money you borrow to purchase the car you want. The more money you borrow, the more you will have to pay back which means higher monthly payments. You should aim to find a car that will effectively support your lifestyle, but still works with your budget constraints.
Down Payment
As a rule of thumb, your down payment for a car loan should be between 10% and 20% of the car’s total value. A down payment is not absolutely necessary, but it helps you obtain financing and kick starts the positive equity you have in your car.
If your credit isn’t the greatest or you’re buying a brand-new car, you should make a down payment closer to 20%. On the other hand, if you’re buying an older car or have great credit, you can get away with a down payment closer to 10%. Depending on your circumstances, you will fall somewhere within this spectrum.
Compare & Negotiate
The best way to find the perfect car loan is to gather a couple offers from different lenders and compare them. Using the above information, pick the most attractive option. From there, you can negotiate an even better deal by offering the lender something else in return. A higher down payment or promised credit improvements are good bargaining chips.
Make & Model
Last, but certainly not least, you need to pick the make and model of the car you want. This is the part where you get to shop around for the car of your dreams! Although, make sure you’re realistic when shopping. While the brand-new sports car may look appealing, can it really support your lifestyle?
Generally speaking, you need a credit score of 700 or greater for a brand-new vehicle and 650 or greater for a used car. If your credit score is below 650, don’t panic! Many individuals still secure car financing with a credit score below 650. In addition, the credit score requirements depend a lot on the lender you’re going with. Some lenders are more strict about credit scores than others.
That being said, you likely won’t get the most ideal loan conditions with a credit score below 600 or be able to drive the newest cars. If this is you, make sure you’re being practical when shopping for cars and car loans. The good news is a car loan can help build credit. While you may have unattractive loan terms now, you can secure more ideal financing in the future with your newly built credit. With poor credit, you will merely need to work your way up!
Credit isn’t the greatest? You have options! Below are some tips and tricks to boosting your credit score before applying for car financing.
In the old days, most individuals could only secure financing from a bank or other similar traditional lender. In today’s world, we are fortunate to have multiple types of lenders to turn to for our financing needs. Below are the various lender types you can consider when seeking car financing.
A car lease involves driving a brand-new car for a fixed period of time in exchange for a specified monthly fee. Unlike with financed cars, you do not own a leased car. This means your monthly payment is merely a fee to use the car, it is not a payment towards ownership of the car. At the end of the fixed period, the customer must return the car or purchase it at market value.
Since leased cars are typically returned at the end of the term, there are stringent rules you must abide by when leasing. For example, you have a limited amount of mileage, cannot modify the car and are responsible for repairs and maintenance outside of regular wear and tear. There is a silver lining though, the monthly payments are typically lower than car loan payments.
The decision between a car lease or a financed car depends a lot on your personal preferences and lifestyle. Generally speaking, it is most ideal to go with a car loan if you:
When you apply for a car loan, you will need to submit a set of documents so that the lender can verify the information and approve your loan request.
Car financing is one of the most common ways to own a car in the modern world. As we explored in this article, car loans have many advantages, but that doesn’t mean it’s right for everyone.
Before making any decisions, it is wise to analyze your current financial situation and assess your financial goals. If a car loan doesn’t fit into your budget or align with your goals, maybe now isn’t the time to buy a car. Maybe leasing is the right option, or perhaps you should hold off until your financial situation evolves. Every individual’s financial situation is unique, what is right for one person may not be right for another. On the flip side, if a car loan sounds right for you, start shopping away!
Mohamed Konate is a personal finance expert, blogger, and marketing consultant based out of Toronto. He is a former financial services professional who worked for many years at major Canadian financial institutions where he managed the marketing strategy around various financial products ranging from credit cards to lines of credit. Mohamed is passionate about personal finance and holds a Bachelor in Business Administration from the University of Quebec (Montreal) and a Master in International Business from the University of Sherbrooke (Quebec).He is also the author of the Canadian Credit Card Guidebook.
