Are you thinking of purchasing a new car? While visions of family road trips, highway joyrides, and that new car smell may be filling your head, chances are you will have to think about something a lot less fun before you drive your new set of wheels off the lot: paying for it.
Most Americans who live in cities where driving a car is necessary are also finding it necessary to take out an auto loan when they purchase that car. In 2018, more than half of all used cars and a full 85.1% of new cars were financed through a loan.
The average monthly car payment on a new vehicle in 2018 was a hefty $545, and the average car loan had an average length of 69 months—that’s over five and a half years.
If you’re thinking of purchasing a new car and taking out an auto loan, it’s important to understand the factors that go into determining your average monthly car payment so that you can determine what sort of loan makes the most sense for you.
Comparing Types of Car Loans
There are two primary types of auto loans: direct loans and dealer financing. A direct loan is a traditional loan through a bank or financial institution, while dealer financing is a loan obtained through the dealership — sometimes referred to as "buy here pay here" (BHPH). A direct loan is much more common, and a dealer may typically sell the loan they make to you to bank or credit union which will then service your account. While this means that the two options are very similar once you begin paying your loan, dealerships may be able to offer special manufacturer-sponsored incentives or other offers that a bank would not.
Factors That Determine Your Car Payment
No matter whether you choose to obtain a loan through your bank or through the car dealership, your monthly payment will be determined by the same factors:
- Your income, credit score, and debt. Your debt-to-income ratio is an important factor that lenders use to evaluate your creditworthiness. If you have a high income and relatively low debt, you will be more attractive to lenders and may come away with better lending terms. However, if you have high income and equally hefty debts, you will be more of a risk to lenders, and thus less likely to qualify for a loan with very desirable terms. If you have a subprime credit score, it may be difficult to obtain a loan at all.
- Age of the car. It may seem counterintuitive, but the newer the car, the better the terms of your loan could be. If something should happen that makes you unable to pay your loan and your car to be repossessed, the bank or dealership may have an easier time re-selling a newer car than an older car—and thus have more of an incentive to take a risk on backing this asset.
- The length of the loan. Shorter loans generally come with more favorable terms because it signals you have a higher ability to pay off your debts in a reasonable period of time. However, a shorter loan will generally come with higher monthly payments because you’ll be paying off the balance in a shorter amount of time.
- The size of the loan and the amount of the down payment. Putting down a sizeable down payment signals to lenders that you are serious about this investment and may lead to a more desirable interest rate. A larger loan, especially if you have a high debt to income ratio, will likely come with a steep interest rate, while a small loan will likely come with favorable terms.
- Annual Percentage Rate (Interest Rate). The annual percentage rate (APR) is the interest rate you will pay each year on your loan, plus fees. Loans on older vehicles generally come with higher interest rates because they have a lower resale value. A variety of factors go into determining the APR you will be offered, including your credit history, market conditions, and special offers. While it is uncommon to have an APR that changes over the life of an auto loan, pay attention to the fine print because a variable rate could cost you!
Before You Buy
In addition to your average car payment, if you’re planning on buying a new vehicle, you should budget for insurance costs, gas prices, taxing and registration fees, maintenance, and repairs, and the realistic resale value you can expect to make back once you sell your car. Keep in mind that prices for insurance and registration can vary dramatically by state. While it may seem a hassle, doing these calculations and research will give you a much more realistic picture of the type of vehicle you can afford to buy than a car’s sticker price and will better equip you to stand firm under pressure at the dealership. If you’re able to, consider driving your old vehicle for longer, carpooling, or taking public transportation while you save for a vehicle.
The Bottom Line
The decision to purchase a car is a decision that should not be taken lightly, and neither should the decision to take out a loan on your car. Consider saving for a down payment to save money in the long run. Shop around for the best loan terms. Compare the dealership’s offer with that from your bank or consider borrowing money from a family member. Review your state laws to determine your rights as a borrower. With a little research, you’ll be well on your way to owning a vehicle that can last you for years to come—and preserving your financial future while you’re at it.