Financing a car is the most popular choice for most car buyers. It comes with the flexibility of paying in monthly installments and making a small down payment.
You can compare the financing option with a cash payment or alternative loans to make the best decision.
Let us help you decide whether financing a car is a good idea for you.
How Does Financing a Car Work?
You find a lender to pay for the price of your purchased car. In turn, you repay the borrowed amount and interest on that money to your lender.
Your lender can be an auto dealer, a bank, or a credit union depending on where you get the right deal. Then, there are variable and fixed-interest car loans in the market.
Choosing the right type of car loan and lender affects your wealth in the long run. It remains in your credit history and certainly affects your credit score.
You can compare different loan options by prequalifying with different lenders. It does not come with hard inquiry, so you can easily compare different loan terms and conditions.
You may need a down payment for certain loan types. Most auto loans do not require upfront cash payment though.
You must fulfill certain qualification criteria such as credit score, proof of income, personal documentation, and other contract requirements before getting the keys to your favorite car.
Before that, you can compare financing a car with buying it with cash. Both options come with certain pros and cons.
Let’s dive in to compare both these options for a car purchase.
What is the Credit Score Requirement to Finance a Car?
FICO and VantageScore are the two most commonly used credit scores that most lenders use to assess your creditworthiness. Both these rating agencies work with the top credit bureaus Experian, Transunion, and Equifax.
Depending on your car financing lender, the credit score requirements will vary.
If you are financing through a bank, you’ll usually require a good credit score above 700 to qualify for a new car financing.
Similarly, you can get a car loan for a used car if your credit score is around 650. Lenders will consider some other factors as well.
You can get a car financing loan with an average or poor credit score as well. Certain lenders like car dealers and private credit unions offer car loans for persons with bad credit as well.
Impact of Credit Score on Financing Rates
Your credit score is the summary of your creditworthiness for any type of loan. Lenders assess your ability to repay the loans by evaluating your credit history.
If you have a good or excellent credit score, lenders will determine to lend safer. Contrarily, if you have a bad credit score, your loan will be considered unsecured by the lender.
Lenders charge higher compensation in the form of high-interest rates for unsecured and risky lending.
Therefore, your credit score will directly impact the total cost of borrowing for your car loan. However, the credit score is not the only factor affecting the interest rates.
You can pledge an asset as collateral to the lender or apply with a cosigner. You should aim to reduce the risks of the lender to get better interest rates.
Does Financing a Car Impact your Credit Score?
Yes, car financing will impact your credit score in one or the other.
First, when you apply for a car loan, lenders look into your credit score. It incurs a hard inquiry that stays on your credit report for two years and costs you a few credit points.
Then, it affects your credit mix and your debt-to-income ratio. Both of these factors affect your credit score. If you had a few loan accounts, adding another one will help your credit mix.
However, adding a new loan account will reduce the average age of other loan accounts. Likewise, a new loan will reduce your debt-to-income ratio now as you’ll be paying more on debt repayments than before.
If you make the installment payments on time and repay your car loan without a default, it will help improve your credit score in the long run.
Lenders look into the credit history of an applicant to know how they repaid their previous loans. Therefore, if you manage it well, your car financing will positively impact your credit score.
Is Financing a Car Good Idea?
There are certain situations when it makes sense to finance a car rather than purchase it with cash. If you manage your car loan well, it improves your credit score as mentioned above.
Considering different factors that come into play for an auto loan like down payment, credit score requirement, and interest rates, you can find these situations where you should choose financing a car over cash payment.
- Interest rates are lower and lenders are willing to negotiate the lending costs.
- You do not have sufficient cash to purchase a car outright.
- You cannot save big enough to purchase a car in the coming years or you have invested the cash to generate income above the interest rate.
- You want to improve your credit score and add a new loan to your credit history.
- You have increased your income or can afford to make monthly payments for the tenure of a car loan.
In short, consider your affordability in the long term before making the final call on a car loan.
When Does it Make Sense to Pay Cash for Buying a Car?
The popular alternative to financing a car is to make a cash payment to buy your favorite car.
Using the cash payment option comes with certain advantages as compared to the financing option.
- You do not need to qualify for a loan and your credit score does not come into play.
- Your monthly budget and regular expenses would not be affected.
- You’ll keep the debt under control as there will be no new loan.
- You’ll save interest costs that may become a substantial saving in the long run. Especially, when your credit score is poor.
- You can use the purchased car as collateral to shop for new loans in the future if you get into financial trouble.
You can sell the car in case of an emergency and do not need to worry about the lender.
Buyers purchase a car within their financial reach when buying with cash unlike overspending habits with financing a car.
Disadvantages of Paying with Cash for a Car
Using cash for purchasing a car comes with some disadvantages as well.
- Investing cash can bring higher returns in the long run than saving from the interest costs.
- It can be a risky move for you financially if you do not have savings for an emergency fund.
- Purchasing a car will not help you improve your credit score and it does not appear on your credit history.
- You may not afford the car outright with cash if you do not have sufficient cash savings.
Alternative Approaches to Buying a Car
You can think of alternative approaches to buying a car than financing or cash payments.
For instance, consider private lenders like peer-to-peer (P2P) lending platforms that offer flexible loan terms. However, P2P lenders usually charge higher interest rates than banks or credit unions.
If you are looking to use a new car but cannot afford it through financing or purchasing, you can lease the car. Leasing terms can be compared directly with financing a car.
The only drawback of this option is that you’ll never own the car despite making monthly payments.
Similarly, you can use your credit card to make a down payment or a portion of the financing deal to make it viable for you and the lender.
Final Thoughts on Financing a Car
The final decision on financing a car or using any other method will depend on your current financial situation.
Financing a car is the best option if you get low-interest rates. Even better if you can get a cash rebate or a 0% financing through a car financing deal.
Using cash to buy a car also makes sense if interest rates are too high. Saving on interest can be significant if your credit score is poor and you anticipate a high-interest rate.
You should consider the cash method only when you have substantial savings for emergency funds. Also, consider the opportunity cost of investing the cash into a profitable investment against purchasing a car.