When buying a new car, you need to know about your financing options. While your savings are a good indicator, you'll also want to look at different car loan characteristics and auto loan terms — and know how much a bank or other lender is willing to loan before you start shopping. To do that, you might want to consider getting prequalified or preapproved for an auto loan.
Prequalification versus preapproval
A prequalification gives you an idea of what a lender may contribute in terms of amount and interest rate on your loan. Most of the time, a prequalification hasn't gone through a complete review process by the lender.
If you're worried about impacting your credit score, a prequalification is your best option. It only involves a soft credit pull, which will not impact your score. It can also be a great way to see what you can borrow without fully committing.
A preapproval is an offer for a loan, including the conditional terms of the amount and interest rate that you can expect over time. Since this process gives you the actual amount you can expect, it's much more involved. You'll likely be asked about your pretax income, the amount you want to borrow, your housing information, your current employment information, your Social Security number and a copy of your ID. From there, the lender will do a hard credit pull, which may affect your credit score. Once the lender has all your credit information, you may be given a loan offer that will help you plan out your car payment costs.
A preapproval is a great option if you feel ready to purchase a vehicle and want to see exactly how much you can afford. While it's a great way to find out what you're working with financially, it's not a guarantee of loan approval or loan terms.
Benefits of shopping around
Understanding your financing options can help you negotiate and avoid overspending on a vehicle that you can't afford. According to Kelley Blue Book, the average cost of a used car in 2023 is more than $26,000. Many drivers might not be able to afford that price without taking out a loan, and knowing how much a lender is willing to contribute can help you narrow your search.
Direct financing, usually a loan from a bank or credit union, often has lower interest rates than indirect financing, like a dealership. Some dealerships also only let you apply for a loan after you've found the car you want, which might make it hard for you to budget for your purchase.
Knowing the amount that an outside lender is willing to offer gives you the leverage in the negotiation, because it provides a better idea of whether the dealership is giving you a good deal.
Loan terms to know
Your loan is going to vary based on your credit score, available funds and preference, but there are a few universal truths when it comes to auto loans. When you're applying for a prequalification or preapproval, consider the interest rate and length of the loan before agreeing to the terms.
Interest rate and annual percentage rate
The interest rate determines how much you'll have to pay back on top of the amount borrowed, so you'll want the lowest rate possible. Auto loans are unique in that they utilize simple interest costs, rather than compounding interest. This means that rather than accumulating interest, you'll only pay back a flat percentage of the amount borrowed. This is to your advantage, as you'll get a better idea up front of what you'll pay on your loan.
You should expect to see your loan rate quoted as the actual interest rate and the annual percentage rate, or APR. APR is made up of the interest rate and any prepaid loan fees like origination fees. The APR is a more accurate reflection of your loan costs per year so it's important to know which costs and factors determine your APR.
The interest rate and APR you get on your loan depends on the market and can vary depending on your credit score. Do some shopping online to determine the average rate for loans in your area before going to a dealership. If your credit score is low or your credit history is short, you may be able to get the loan with a co-signer which may get you a better rate. Getting a lower percentage rate on the loan means you'll pay less interest over time.
Loan length
The length of your loan depends on how much of a monthly payment you can afford and the cost of the car. Remember that a vehicle will usually depreciate by nearly 20% after one year of ownership, so avoid loans that are longer than eight years. Ideally you should look for loan terms of 60 months or fewer to reduce the impact of depreciation. The length of your loan term will directly impact your monthly payment, so be sure to consider this when setting your budget.
You'll want to calculate exactly how much you'd pay monthly to avoid any surprises. A longer loan can get you a lower monthly payment, but you may end up paying more in the long run because you'll be making payments for a longer time.
For example, if you borrow $30,000 with a six-year financing period at 4% APR, you'll pay $470 per month with a total of $33,882 paid over time. If you borrow $30,000 with a three-year financing period at 4% APR, you'll pay $887 per month for a total of $31,929 over time. With the lower payment you may have had an easier budget but you paid nearly $2,000 more in interest over the length of the loan than you would have with the shorter loan term.
You'll need to decide what you're comfortable paying each month, and whether it's more important to have a lower monthly payment or to pay less overall.
Getting preapproved or prequalified for a loan is a great way to ensure that you're getting the best rate for your purchase. Ready to get started? Learn more about how you can get a loan decision in minutes with USAA's simple online application.
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