How to finance a car the smart way

One of the biggest mistakes people make when buying a new car is forgetting to include the cost of auto financing in the total price.

For example, let’s say you talk the dealer into taking $2,000 off the sticker price. Awesome work! 

However, capitalizing on your excitement, the dealer tricks you into putting $0 down and stretching your car loan term from three to four years to keep monthly payments low. That might sound great on paper, but in reality, you’ll end up paying $3,000 more in interest alone. 

If you’re willing to negotiate the price of the car, you shouldn’t ignore the rates and terms of your car financing. I made this mistake the first time I bought a car and vowed never to do it again.

If you’re in the market for a new car, don’t wait until you’re in “the box” (what some dealers call the offices where you finish the paperwork) to think about your financing. Review these time-tested steps now to save a ton of money by the time you drive out of the dealership in your new wheels.

The first step to securing an ideal car loan is to check your credit report and score. You can do so right now, and for free, via Credit Karma. 

Dealerships will often advertise very good interest rates on new cars: 2.9%, 1.9%, sometimes even 0%. What they save for the fine print is that these rates are only available to car buyers with the best credit — meaning those with a score of 750 or better.

Dealers and banks will still “give you” a car loan if you have a poor credit score. That’s because they know they’ll make tons of interest off of you, and if you don’t pay, they can just repossess it while you’re inside Trader Joe’s.

Buyers with credit scores in the low 700s can still get a decent interest rate, but they may not qualify for the best promotions. And rates rise quickly for scores below 700. If you’re a borrower with a below-average credit score (under 650), you may be presented with car loan rates of 10% or more.

If you have an excellent credit score (750+), you can usually get the best financing rates right from the dealership. I’ve literally never said this before in all my time at Money Under 30, but in this case, you really don’t need to pre-shop around for the best rates.

This is because the dealer themselves will serve as a broker and show those with great credit the best options across multiple lenders competing for your high-credit patronage.

The tables are completely turned when you have a poor credit history, though. You’re the one the dealer will take advantage of, and you certainly won’t qualify for anything near “good” when it comes to rates offered at the dealership.

In this case, you should thoroughly research rate options online before you go to the dealership. Rates available from online lenders and/or the usual credit union/bank you work with are likely more competitive than the in-house rates the dealer will throw at you.

Regardless of your credit score, a dealer will always try to sell you low monthly payments, zero down, and long car loan terms of four, five, or even six years. 

This is the opposite of what you want. 

Lower monthly payments are a manipulative and old-as-dirt sales tactic. Dealers like them because they:

1. Make it seem like you can afford more car than you really can
2. Make it seem like you’re getting a deal (when you’re actually getting screwed)
3. Create breathing room to sell you extras
4. Confuse buyers and pacify negotiations
5. Please their lenders since they’ll make gobs of interest off of you

Suddenly a $470 car payment becomes a $350 car payment. And yet, you’re not paying any less for the car. In fact, you’ll be paying much more in interest.

The longer you take to repay a car loan, the more interest you’ll pay. But that’s not all. Many times banks will charge higher interest rates for longer loans, further increasing your cost of credit.

It’s tempting to stretch out an auto loan over five or even six years to get to a more comfortable monthly payment, but this means you’ll pay a lot more in interest and almost certainly be upside down on your car for nearly the life of the loan.

In addition to shortening the term of the auto loan, you also want to minimize the principal. 

The “principal” of the loan is the total amount you borrow, and thus have to pay interest on. When a dealer offers you a loan with zero down payment, they’re basically saying let’s maximize your principal so that my lender can charge you more interest.

Don’t do it!

Make at least a 20% down payment on your new car so that you can reduce your principal and thus the total amount of interest you’ll end up paying. 

If you can’t afford to put 20% down before you take a loan out, chances are you won’t be able to afford the monthly payments plus interest over the course of the loan term itself.

Exhausted by your shrewd negotiations and preparedness, the dealer may still try to roll miscellaneous expenses into your financing options. These may include their dealer fees (~$800), taxes (~7%–10%), extended warranties, and the cost of optional extras. 

For example, they probably know that a $2,500 infotainment system upgrade is a hard sell, so they’ll say “upgrade your infotainment for just $17 per month.” Sounds innocuous, but you might end up paying $900 in interest or $3,400 total on that friggin’ screen alone. 

Asking for an itemized invoice for all of these expenses, and paying cash, ensures a few things:

1. The dealer will have a harder time hiding BS fees from you.
2. You won’t pay for extras that you don’t truly want/need (like a 13” vs. 8” screen).
3. You won’t pay $1,000+ in additional interest.

When negotiating, always ask for the “out-the-door price” — this is code for the bottom-line, no-nonsense price of the vehicle. Then discuss finance terms. 

Gap insurance (guaranteed auto protection insurance) is something car dealers and lenders sell you to cover the “gap” between what an insurance company thinks your car is worth and what you owe on your car loan in the event you’re in an accident and the insurer declares the car a total loss.

Let’s say you crash your car. The insurance company pays out $10,000, but you still owe $12,000 on the loan. Gap insurance would cover the remaining $2,000. 

The thing is, if you structure your auto loan properly with a 20% down payment and a short, three-year term, you shouldn’t need gap insurance. With good loan terms, there should never be a scenario where you’d owe more than the car is worth. 

So if your dealer is really pushing you for gap insurance, that might be a sign that your loan terms need re-evaluating.

Unless you buy a rare Ferrari, your car is not an investment, it’s a depreciating asset. In fact, most cars will lose half their value in five years. Most luxury and sports cars depreciate even faster.

That’s why you generally want to pay off your car as soon as possible. Dealers will try to talk you into some combination of a low down payment, low monthly payments, and long loan terms (four, five, even six years). Why? Because they and their lenders will make tons of money off of you in interest that way. 

The longer you take to pay off your auto loan, the higher the likelihood that your car will go “underwater” or “upside down,” meaning you owe more on the loan than the car is worth (also known as negative equity). That’s an awful place to be, because even if you sell the car tomorrow, you’ll still owe thousands on a car you don’t even have anymore. 

That’s not to say that all auto loans are bad. Most of us use cars to get to our jobs and don’t have the cash lying around to buy a reliable ride, so we need a car loan. That’s totally cool! 

But the key difference is this: An auto loan should help you get a car that you can afford, not one that you can’t afford. 

I have the credit and income to go out and get a loan for a BMW M3. And I would love that car. But that doesn’t mean I should get it. What the dealer will tell you you can afford for dealership financing and what you should spend are two very different things.

Use MU30’s car affordability calculator to see what you can truly afford for an auto loan payment.

Read more: How much should you spend on a car?

Unless you’re looking at 0% or another really low APR (annual percentage rate), the best way to buy a car is with cash. If you have to get a car loan (whether that’s a personal loan or dealer financing), it literally pays to be as pragmatic as possible.

Check your credit score, and if it’s below 700, research the rates offered by online lenders and your usual credit union or bank before going in to the dealership. Then try to use those offers you found as leverage to get the lowest APR possible from the dealer. They may or may not drop their rate when presented with a competing offer, but at least you tried.

These steps will improve your chances of loan approval at an affordable rate. If during your research process you realize that you can’t really afford that cool car you were eyeing…well, better to learn that now than after you buy it!