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Chapter 3: Your Credit Score and Financing

Your Credit Score
If you are planning to get a loan to purchase your car, having a good credit score is essential. Not only does it have a major impact on the interest rate you can get, but if your score is too low, you may not be able to get any financing at all. Even if you are leasing instead of buying, your credit score will likely be checked.

Your credit score is a numeric summary of the information in your credit report and is formulated to predict the risk you will not repay what you borrow. The most commonly used scoring model is issued by the Fair Isaac Corporation. Called a FICO score, it ranges from 300 to 850, with a higher score being indicative of less risk. To get a car loan with a reasonable interest rate, most lenders require a score of at least 620. To get the best interest rate, you usually need a score in the mid-700s.

What if your credit score is low and your application is denied? One option is to ask someone with good credit to co-sign on the loan. Be especially careful with this type of arrangement – any late payments you make will not only reflect poorly on your credit report but your co-signer’s as well. Another option is to work on improving your credit score so that you can get a loan on your own. It may take time, but there are many things you can do:

  • Always pay on time: A commitment to never make a payment late again is one of the most powerful steps you can take to improve your credit rating.
  • Pay down existing debt: Even if you have never missed a payment, a large debt load will lower your score. Explore ways you can lower your interest rates and free up cash to pay more than the minimums.
  • Avoid taking on additional debt: Besides paying down existing debt, make an effort to not take on more debt in the future. For revolving credit, ideally you should not charge more than you can pay off in full the next month, but at the very least, keep the balances under half of the credit limits.
  • Pay collection accounts: If you have collection accounts on your credit report, you can give your score a boost by paying them. Request payment arrangements for balances you can’t afford to pay in full or settle, and make sure to confirm the agreements in writing.

 

Financing
A car loan is a legal obligation. Make sure you understand the following aspects of the loan agreement before you sign any documents:

  • Amount you are financing (borrowing)
  • Annual percentage rate (APR – the interest you are charged annually expressed as a percentage)
  • Finance charges (the total amount borrowing will cost you)
  • Payment amount and number of payments
  • Whether there are any penalties, such as a late-payment or pre-payment penalty

The lender is required to disclose all the above information in the Truth in Lending Disclosure Statement, which must be given to you before the loan is closed (finalized). Read this statement carefully, and don’t be afraid to ask your lender questions.

There are three main options for financing: the dealership where your purchase the car, a credit union/bank, or a finance company. (Dealerships generally do not directly provide the cash but rather arrange financing on your behalf with another company, commonly the manufacturer’s financing division.) Dealerships often offer low promotional interest rates - or even zero percent rates on certain models - but that may only be on certain cars. That is why it is a good idea to see what financing your financial institution offers. An added bonus is that you can use a loan from your financial institution to purchase a car at any dealership. Conversely, if you get approved for a loan through ABC Dealership, you won’t necessarily be able to use that loan to purchase a car at XYZ Dealership.

Finance companies often specialize in offering subprime loans – loans to people with poor credit. Subprime loans come with higher interest rates than prime loans. If you can only get a subprime loan through a finance company, it may be preferable to work on improving your credit score first and hold off on getting a new car until you can get a loan with a better interest rate. This example shows the difference between a loan at 5% interest (a good rate) and one at 15% (a rate often offered by finance companies):

  Prime Loan Subprime Loan from Finance Company
Amount Financed
$16,000
$16,000
Interest Rate
5%
15%
Loan Period
60 months
60 months
Monthly Payment
$302
$381
Total Interest Paid
$2,116
$6,838
Total Cost
$18,116
$22,838

As you can see, you may have to pay quite a bit extra in interest with a subprime loan – $4,722 in this case.

What if you are buying a model that comes with zero percent financing from the dealership? Zero percent financing may sound like an amazing bargain – after all, how can you beat no interest? – but it isn’t always. You can’t get the rebate if you take zero percent financing, and the dealership may not be willing to negotiate the price of the car. Often the length of the loan is shorter too, resulting in high monthly payments. Consider this example:

  Loan from Financial Institution Loan from Dealership
Purchase Price
$20,000
$20,000
Down Payment
– $2,000
– $2,000
Manufacturer's Rebate
– $2,500
– $0
Amount Financed
= $15,500
= $18,000
APR
5%
0%
Loan Period
60 months
36 months
Monthly Payment
$293
$500
Total Interest Paid
$2,050
$0
Total Cost
$17,550
$18,000

In this case, you will actually save $450 by taking the five percent loan, with much more reasonable payments. Even if zero percent financing provides the best deal, keep in mind that you usually need to have stellar credit to qualify.

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