On Sunday, the New York Times reported about borrowers paying sky-high interest rates for used cars. They correctly identified that many elements of the sub-prime mortgage crisis can be seen in the auto lending market today.
We agree with the NY Times and we will give you:
- Tips to avoid the sub-prime auto trap if you are looking to buy a car
- Tips to get out of the sub-prime auto trap if you are stuck there today, and
- Our view of why the system is such a mess
Know before you go
If you are buying a car, you need to do most of your work before you go to the dealership. When you first step foot on the lot, you should already know:
- Your credit score
- How much you can afford to pay each month
- The interest rate and loan amount that you have been approved for
If you don’t know this information, then you will be depending upon the auto dealership to guide you. And that would be a mistake.
1. Your credit score is your ticket to financing. Some credit card companies provide your FICO score free of charge on your statement. There are other sites that can provide a free credit score (not FICO, but a good approximation), like CreditKarma. A score above 700 makes you prime, and will give you access to the best deals. Below 700 means you need to do a little more homework. Remember: you do not need to be rich to have a good credit score, you just need to pay on time and not max out your cards. Learn how to get a 700 score here.
2. You need to create a budget and understand how much you can afford to pay (comfortably) each month. Keep in mind that people always underestimate their expenses when making a budget. The auto dealer will do his best to talk you into a more expensive car. When a dealer lies about your income on an application, he is only helping himself – not you.
3. Once you know your score and how much you can afford, you should get pre-approved.
- If you have a score higher than 700, then there is probably no better deal than a credit union like PenFed (who offers a 5 year used car loan at 3.74% APR). Anyone can join PenFed, but your local credit union will also probably offer a great rate. In addition to your credit score, PenFed generally wants a debt burden (monthly expense as a percent of monthly income) to be less than 50%. And so should you.
If your score is below 700, then you should still speak with your credit union. If they do not approve you, then go directly to CapitalOne, who has a Blank Check program and is one of the largest lenders in this space. In 10 minutes, they will tell you how much you can borrow, and at what interest rate. They will then give you a “blank check” that you can take to one of the 12,000 dealers who partner with them. Borrowing with the Blank Check program will be cheaper than borrowing at the dealership.
Once you know your score, how much you can afford to pay each month, and your pre-approved interest rate, you can walk onto the dealers lot with confidence.
Once on the lot, remember:
- Avoid “rolling over” debt. You do not want your loan to be more than 100% of the value of the car. If you have no other choice, then you really need to consider a cheaper car, to keep the total amount financed below 100%.
- Beware the warranties and add-ons sold at the end of the deal. They wait until the very end, and try to sell expensive warranties – and then add them to the loan.
- The dealer may be able to beat the financing you bring to the lot. If you are buying a new car, there may be a 0% offer, for example. But make sure you compare the full cost of the loan he tries to sell you to your pre-approved offer (including any fees or points).
- Don’t let the dealer talk to you only about monthly payments. They can give you a low monthly payment – but charge you a lot more – if the interest rate is high and the loan term is very long.
Already Stuck in a Bad Loan?
So, you wish you would have done all of these things, but, you didn’t and now you have a loan at an outrageous interest rate.
There are ways to get out of the mess. The most important first step is building a plan to get your score above 700. That means paying your bills on time every month, not maxing out new credit cards, and keeping open credit available. Once your score is above 700, you can find a lot of options to refinance your car loan, up to 100% loan-to-value. (If your car is worth $100 and your loan is $100, then you have 100% loan-to-value. If your car is worth $100 and you have a $50 loan, than it is 50%.)
Again, one of the best refinance programs out there is PenFed. You need a score above 700 and a debt burden of 50% or lower. Once you get there, you can slash the interest rate on your car, below 3%. The best way to get out of a subprime loan is to make yourself prime, and then refinance.
If you can not get approved at PenFed, you may want to speak with your local credit union.
If your score is lower, you may want to consider re-financing at CapitalOne, who also has a refi program.
If your loan is above 100% LTV, then your goal is to get it below 100%. One way is to consider a low interest rate loan from a credit union to cover the portion above 100%. For example, PenFed offers 9.99%. You could also consider a loan from LendingClub* or Prosper.
Unfortunately there is no magic solution. But, once your balance is below 100% and your score is above 700, you can dramatically cut the cost of debt. So, your goal should be to improve the score (payments over time) and reduce the LTV (including a personal loan) to reach that point.
Why it will never be good at a dealership
Dealerships make money in two big ways: selling cars and financing cars.
Selling cars is straight-forward: they want to sell you a bigger car with more features. Beware.
Less clear is the money they make on financing. The dealer discount is a payment that the lender makes to the dealer. Those fees are not always transparent. And the dealer will want to put you in the loan that pays him the most, not in the loan that gives you the best deal.
That is why you should always walk onto the lot knowing how much you can afford and already having a great interest rate. If the dealer can beat it – great. But you will have control.
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