Buying a car is a major investment, and a major goal of the ritual is to negotiate the best price. But, that's only part of the process. The next step is to qualify for a car loan at an interest rate that gives you a reasonable monthly payment and fits comfortably within your budget.
The truth is, just about anyone can get an auto loan, regardless of their credit score. The difference is with the interest rate. Buyers with high credit scores will get the lowest rates, while those with low scores will be charged the highest interest rates.
Let's examine how your credit score can affect your monthly payments, your budget and your car-buying decision.
Interest Rates Based on Credit Scores
According to recent data from Experian, the average credit score for a buyer of a new car was 721. A used-car buyer had an average score of 657.
Credit scores are grouped into five categories from high to low. Here are the latest interest rates reported by Experian for new cars that illustrate the huge difference between the highest rating, super prime, and the lowest, deep subprime:
Super prime – 781 to 850 – 3.65%
Prime – 661 to 780 – 4.68%
Nonprime – 601 to 660 – 7.65%
Subprime – 501 to 600 – 11.92%
Deep subprime – 300 to 500 – 14.39%
Notice how the rate for “deep subprime” buyers is four times the rate offered to “super prime” borrowers (14.39% vs. 3.65%).
Suppose you want to buy a new car and finance $30,000 for five years. If you have a super prime credit score, you will receive the best interest rate of 3.65%. Your monthly payments will be $548, and the total interest paid on the loan will be $2,866.
On the other hand, if you have a deep subprime credit score, your interest rate will be 14.39%. Your monthly payment will jump to $704, and you will pay $12,248 in interest over the life of the loan. In this case, a low credit score will cost you an additional $9,382 in interest, and your monthly payment will be $156 higher ($704 - $548).
Will this higher monthly payment fit in your budget?
Average Interest Rates for Used Cars Based on Credit Scores
Interest rates for loans on used cars are higher than rates for new cars. According to Experian, the latest interest rates for used cars are as follows:
Super prime – 4.29%
Prime – 6.04%
Nonprime – 11.26%
Subprime – 17.74%
Deep subprime – 20.45%
What are the differences between good credit and bad credit in financing costs for used cars?
If you are financing $20,000 over five years to buy a used car and have super prime credit, your loan payments will be $371 per month. You will receive an interest rate of 4.29% and pay $2,257 in interest over the life of the loan.
By contrast, if you have a deep subprime credit score, your interest rate will climb to 20.45%. Your monthly payment will increase to $535 over five years, and you will pay a total of $12,094 in interest: a difference of $9,837 over the interest paid if you had super prime credit.
For used cars, the rate for deep subprime borrowers is almost five times the interest rate for super prime customers (20.45% divided by 4.29%).
Read More: Will a Score of 607 Get You a Car Loan?
How to Get a Lower Interest Rate
As you can see from these examples, your credit score can have a huge impact on your monthly payments, the amount of interest that you pay and even your ability to afford to buy a car. In some cases, these higher monthly payments may not fit into your budget, and you may have to look for a cheaper car, just to get lower payments.
So, what are the steps you can take to improve your credit score? Follow these steps:
Request copies of your credit reports and credit scores. You are entitled to get a free credit report each year from the three credit reporting agencies – Transunion, Experian and Equifax – at AnnualCreditReport.com. You can get your credit scores for free at Credit Karma.
Look for errors and negative information. Make corrections for any incorrect addresses and employers. If you see any negative reports that you believe are in error, file a dispute with the credit reporting agency. They will have 30 days to respond verifying the claim or removing it from your report.
Bring past due accounts current. Bring any past-due payments up to date immediately. You want to take care of these past-due balances before they get sent to a collection agency, which will cause even more damage to your credit score. If the amount due is large, and you can’t pay it off in one payment, contact the creditor and arrange a payment plan.
Pay off accounts with collection agencies. Contact the collection agency and make arrangements to pay these off in full. The collection report will remain on your credit report, but, at least it will show a zero balance and give a more positive impression to a lender.
Pay down your credit card debt. Lenders are especially interested in your credit utilization ratio. This metric is the amount of your credit card debt divided by the total maximum credit lines. If you have total credit card lines of $8,000, and you owe $4,000, your credit utilization percentage is 50%. Lenders like to see this percentage at 30% or less. Always make more than the minimum payment to start reducing the debt, and make payments twice per month instead of just one.
Don't open any new accounts. Lenders will think that you're having financial issues and need to borrow more money. Remember that each application will create a "hard pull" inquiry, which is a negative on your credit score.
Keep existing accounts open and active. The longer that your accounts have been open adds to a positive credit history and improves your credit score.
Be Prepared Before You Go to the Dealer
The best strategy is to get pre-approved for your loan before shopping for a car. Here’s why.
Dealers want to sell cars and make a profit. But, they also make a profit on any financing they offer to customers because lenders share their loan profits with the dealers.
The reality is lenders don't want to make a lot of loans to super-prime borrowers. There is a lot of competition for this class of buyers and profits are low for these types of loans. Lenders make more money with loans to buyers with less-than-stellar credit scores. As a result, dealers have an incentive to offer financing to buyers with lower credit scores because they make more money.
After you have reviewed your credit reports and know your credit scores, you will be in a better position to negotiate terms with the dealer. If you already have a car loan approved before going to a dealer, you won't be in the position of being forced to take the loan terms and interest rates being offered by the dealer. Don't forget that it's in the interest of the dealer to persuade you to accept their loans with the highest interest rate possible because they will make more profits.
Preparation is the best way to take the emotions out of your car-buying fever and prevent you from getting locked into high monthly payments that may wreck your budget.
Read More: The Best Auto Loan Interest Rates for 2020
Shop Around for the Best Loan Terms and Rate
Dealerships aren’t the only source for auto loans. They’re convenient, but they don’t always serve the best interests of the buyer. You have other choices to get preapproved for a car loan.
Banks – If you have a personal relationship and an account in good standing with your local bank, that's the first place to start. Your local banker will probably be aware of your financial history and will be able to find ways to approve your loan unless you have subprime credit that falls below the bank's minimum requirement.
Credit unions – Generally, because they are nonprofit, credit unions offer rates on auto loans that are slightly lower than bank rates. If you’re not already a member of a credit union, look around for one in your neighborhood to join.
Online lenders – Applications to online lenders are quick and easy. Online lenders will accept applications from buyers with credit scores as low as 500.
Try to get approvals from two or three lenders so you have several for comparison. Make all your applications within a short time period, say 14 days. Each lender’s credit check will create a “hard pull” on your credit report, but if they all occur within a short time, they will only count as one inquiry and have less of a negative impact on your credit score.
How your Credit Score Affects Your Insurance Rate
Your credit score not only affects the interest rate on your car loan, but it also affects the cost of insurance for your car. While lenders use credit scores based on FICO, insurance companies use a different credit scoring model, but it is still based on your basic credit profile.
Lenders and insurance companies have different concerns. Lenders are worried that a borrower will be late on their loan payments within the next 24 months, whereas, insurance companies are concerned that the borrower will file insurance claims that exceed the premiums collected.
Insurance companies have data showing that consumers with low credit scores tend to file more insurance claims. As a result, insurance companies charge higher rates to cover this additional risk. Therefore, improving your credit score will not only get you reduced interest rates and lower monthly payments, but it will also get you lower insurance premiums.
One final word: Even if you currently have bad credit and have a car loan with a high interest rate, continue to work on reducing your credit score and look to refinance your auto loan when your score is more attractive.
- Experian: Auto Loan Rates by Credit Score
- Credit.com: What Credit Score do I Need to Buy a Car?
- US News: What is a Good Credit Score to Buy a Car?
- AnnualCreditReport.com: Free Credit Reports
- Bankrate: Auto Loan Calculator
- Experian: How Much Does Credit Score Affect Auto Insurance Rates?
- Progressive Insurance: Is an Insurance Score the Same as a Credit Score?
- Credit Karma: Free Credit Scores
- U.S. News & World Report. "Average Auto Loan Rates in February 2020." Accessed Feb. 13, 2020.
- Experian. "Which Credit Score Is Used for Car Loans?" Accessed Feb. 13, 2020.
- Fair Isaac Corp. "What's in my FICO Scores?" Accessed Feb. 13, 2020.
- Fair Isaac Corp. "Credit Checks: What are credit inquiries and how do they affect your FICO Score?" Accessed Feb. 13, 2020.
James Woodruff has been a management consultant to more than 1,000 small businesses. As a senior management consultant and owner, he used his technical expertise to conduct an analysis of a company's operational, financial and business management issues. James has been writing business and finance related topics for work.chron, bizfluent.com, smallbusiness.chron.com and e-commerce websites since 2007. He graduated from Georgia Tech with a Bachelor of Mechanical Engineering and received an MBA from Columbia University.