When you decide to buy a car from a dealer, you may choose to finance it if you don’t have all of the money upfront. And with car prices getting more expensive every year, this is a fairly common scenario. There are several options when deciding how to finance your next car.
You can go through the dealership and their finance company to obtain a car loan. You can also talk to your own bank or other financial institutions to get a loan approved.
Whatever route you decide to take, you’ll more than likely be required to make a down payment, so it’s important to know what it is, why you need one, and how much it will be.
What is a down payment?
A down payment is cash used to pay for a portion of the cost of the car. It comes out of your own funds and reduces the amount of money you owe on the car. Consequently, it also reduces the amount of the loan you need to purchase the car.
Finance companies and banks ask for a down payment to help reduce their risk. A down payment serves this purpose in two ways.
First, it puts some of the risk on you instead of placing it all on the lender. If you fail to make the loan payment, you lose that down payment.
The second reason for a down payment is that it reduces the amount owed in case the lender has to repossess the car. If you can no longer afford the payments, the lender will take the car and sell it.
Since vehicles depreciate, they are not worth as much as when you bought it. It can be difficult for the lender to get back all the money owed when the car is sold unless a down payment has already reduced the loan below the car’s value.
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How to Get a Down Payment
You can get the money for a down payment on a car in several ways, depending on whether you have a current vehicle or not. You can:
- Trade in your current vehicle to the dealer
- Sell your current vehicle privately and use the funds for the down payment
- Save up cash
- Ask for money from family
Sometimes you can even get a small personal loan for the down payment, but it will increase the amount you have to pay out each month.
Why You Want to Have a Down Payment
A down payment provides many benefits – some for you and some for the lender. The more money you put down, the better the advantages.
Lower Interest Rate
Perhaps the best advantage is that you can probably get a lower interest rate and better terms for your loan, especially if you have poor or fair credit. With a bigger down payment, you become less of a risk for lenders and they can afford to give you a better loan.
Better Chance of Loan Approval
Having a nice down payment increases your chances of being approved for a car loan. Another benefit is that it enables you to qualify for a more expensive car. Lenders look at your overall debt-to-income ratio when deciding to approve a loan and for how much.
Because a down payment lowers the amount owed, your monthly payments will be lower, which means you may qualify for a more expensive vehicle.
For example, you may be looking at a car that would have a monthly payment of $450 but you only qualify for a loan with a monthly payment of up to $420 per month.
If you increase your down payment to decrease the amount you need to be financed, you may lower your monthly payments to the correct amount to get qualified.
Lower Monthly Car Payments
Your monthly car payment will also be lower with a down payment, and your total amount paid will be lower because you won’t be paying interest on that portion.
A down payment also gives you more equity in your vehicle, which means you won’t owe more than it is worth. This is important if your vehicle is a total loss in a car accident. It also helps offsets the first year of depreciation; especially with a new car, as they tend to lose much of their value as soon as you drive it off the lot. And finally, it helps prevent becoming upside down on a car.
See also: How to Finance a Car in 5 Easy Steps
How Much Do You Need?
Now you understand the importance of a down payment and the reason to have one before you apply for a car loan. Your next question is probably about how much you’ll actually need.
For a used car loan, you should generally put down 10% or more of the purchase price. Since new cars depreciate faster than used cars, lenders may require that you put down more for a new car.
While many experts say 20% or more of the purchase price for a new car, the actual amount necessary for a car loan varies. It’s based on several factors. However, it’s best to put down as much as you can afford.
Your Credit Score
The single most important factor in determining how much of a down payment will be required is your credit history. If you have a stellar credit profile, you may need only a small down payment or even none at all.
If you have a poor or fair credit history, you may be required to have a substantial down payment. Even people with poor credit can often get auto financing if they have enough of a down payment.
The Cost of a Vehicle
Generally the more expensive the vehicle, the more you will need as a down payment. This isn’t a hard and fast rule, and it often depends on your credit score. While lenders look harder at the borrower than the car, it will be a factor in their decision.
Dealerships often run a special promotion that says no down payment required. This is to entice buyers who don’t have extra cash to come in and buy.
They may also offer to take your old vehicle as a trade-in, using it as a form of down payment. In this instance, they may have no requirements on the amount or percentage of the down payment, just that you have one.
Remember that the amount needed for a down payment may also depend on what it will take to meet DTI requirements. A lender may tell you that you have been approved for a loan if you can come up with a certain dollar figure for the down payment.
Why a Larger Down Payment is Better
It’s important to realize that many zero down offers may not be in your best interest. While they may sound appealing if you don’t have a trade-in or cash, they don’t help you out in the long term.
For one thing, your payments will be higher, which increases your risk of default. They also increase the likelihood that you will owe more than what your vehicle is worth.
If your vehicle is involved in an accident and is considered to be a total loss, the car insurance company will only pay out the amount equal to the car’s current value. When you owe more than that value, you’re still responsible for paying the difference.
Many times, this amount can be rolled into a new loan when you buy a replacement car. However, you have just compounded the problem because you now owe even more on another car than what it’s worth.
Once you decide you want to buy a car, you should start saving for a down payment. Even if you have a vehicle to trade-in, it may not be enough to make that 20% mark that many lenders like to see. You can add cash from your savings to the trade-in amount.
The best way to purchase a vehicle is by working with the amount you have for a down payment. Instead of finding a car you like and hoping your down payment is enough to qualify for financing, start with the amount you have to use for money down.
For instance, say you have saved $1500 for a new vehicle. You could look for vehicles in the $7,000 to $8,000 range to have a 20% down payment. While you won’t find many new cars for that price, the same concept works if you plan to finance a used vehicle.
If you have a trade-in that values at $3,000, you can now look at vehicles priced over $20,000. Just know it’s best to start with the amount you have to put towards a vehicle rather than browsing cars for sale and hoping a lower down payment will be enough.
Does a smaller or no down payment ever make sense?
You may be wondering if a high down payment is best for all purchases. For the most part, the answer is “yes.” However, there is a time when it may make sense to not have a down payment or a smaller amount for your down payment.
If interest rates are low, you may put your money to better use by investing it. You’ll need to make more with that money invested than what it costs to finance the car for that same amount.
To determine your costs, you need to know your return on investment. You also have to calculate the number of your payments with the higher and lower down payments to know the difference, which should be less than what you will receive with your investment.
A car down payment is not only a requirement for most car loans, it’s also a valuable financial tool to help you save money. Understand the importance of saving for a vehicle and how it can help you afford the car you really want and reduce your monthly payments.
Once you understand the value of paying money towards your vehicle, it’ll be easier to focus on saving before you go car shopping.