Financing a Used Car
- Last Updated: Wednesday, 17 February 2021
This is the final article in our used car buying series, and it's going to address the question of financing. At this point, a car has been identified that meets both the driver's functional requirements and budget. The car was inspected by a mechanic, and the warranty on the vehicle can be found in the Buyer's Guide.
With that phase of the research completed, it's time to figure out how to pay for the car. When it comes to used car financing, there are two options. The first is to pay for the car in full. For many people, especially consumers looking to purchase a used vehicle, this is an unpopular choice.
The second option is to finance the car's purchase over time. With this choice, the total cost of ownership increases. Not only does this option require payment of the money owed on the car, but it also includes interest, loan administration, and application fees. When shopping for a car loan, the Annual Percentage Rate, or APR, can be used to compare offers by various lenders. The lower the APR, the lower is the total cost of the loan.
Generally, the financing terms offered on a used car are shorter than those available on a new car. This is because some of the vehicle's serviceable life has already been consumed. At this point, buyers need to balance the size of their monthly payments with the term, or length, of the loan.Typically, buyers would be offered a one to three year financing arrangement for a used car. Interestingly, even though the price paid for the vehicle is considerably less than a new one, the monthly payments may be nearly as high. The shorter term of the loan coupled with a smaller (or no) down payment and a higher interest rate to compensate the lender for the risks associated with used cars can result in a surprisingly high monthly payment.
Car Loan Calculators
If affordability is a question, we have a number of online car loan calculators that can help with the decision-making process. In that section of this website, there are tools that can help figure out how large a car loan someone can afford, or whether or not it's better to lease or buy a car. We even have a calculator that helps to figure out how fast a car depreciates in value.
Unfortunately, there aren't as many financing options with a used car. Larger institutions such as Chase and Wells Fargo provide offers for the new car market, but typically don't get involved with used cars because the condition of the vehicle is important. It's much easier to use the manufacturer's VIN to immediately value a new car, while the overall condition of a used car requires careful inspection. The risk to the lender is the buyer overpaid for the vehicle, and the likelihood of a negative equity position is much greater (explained later on).
The following institutions typically write used car loans:
- Local Banks: with a greater interest in serving the local community, a local bank may offer loans on used cars.
- Credit Unions: if offered at work, credit unions will typically finance the purchase of a used car for its members.
- Dealerships: to ensure a robust market for used vehicles, dealerships will almost always offer financing too. Since they're familiar with the condition of the car, they're in the best position to understand its value.
Negative Equity Example
Let's say Haley purchased a used car for $8,000 with 90,000 miles on the engine. Let's also assume that she put a down payment of $500 on the car, and financed the remaining $7,500 at 12% for three years. Twelve months later, the car has 110,000 miles on it, and its fair market value is now $5,000. But the outstanding balance, or loan principal, after only 12 months is $5,300!
This means that if Haley had to sell the car, or it was totaled in an accident, then she would be paid $5,000 for the car. Unfortunately, she will have to pay the lender $5,300. In this example, her equity in the car was a negative $300.
This happens all the time, so it's important to avoid this situation. Our article on Gap Insurance explains how consumers can protect themselves if they have negative equity in their car.
This last option avoids financing the car in the first place. Believe it or not, most dealerships are quite happy to take cash for a car. (We're really talking about a cashier's check, carrying around a large amount of "cash" is a very risky undertaking.)
Advantages of Cash
If someone's monthly household budget is already tight, they really should consider paying cash for a used car; perhaps even purchasing a less expensive car than originally planned. To many people, the car they drive is a demonstration of their "status" in the community, and this sense of pride accounts for the fact that many people drive around in cars they can barely afford. Avoid this situation by putting personal pride behind, and focus on the family's financial health instead.
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