When purchasing a vehicle from a dealership, financing may be a viable option if you’re unable to pay the full amount upfront. With the continuous rise of car prices, this is a common scenario for many consumers. To finance your new or used car, there are various options available.
You can opt to get a car loan through the dealership’s finance company or approach your own bank or financial institution to secure an auto loan. You can also choose one of the best auto loans from lenders online. Regardless of the path you choose, keep in mind that a down payment will likely be required.
What is a down payment?
A down payment is cash used to pay for a portion of the cost of the new 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 monthly car payment, you lose that down payment.
The second reason for a down payment on a car is that it reduces the amount owed in case the lender has to repossess the car. If you can no longer afford the monthly 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
Depending on whether you already own a vehicle, there are a few ways to come up with the money for a down payment. Here are some options:
- 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 car down payment, but it will increase the amount you have to pay out each month.
Why You Want to Have a Down Payment
When buying a new car, 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 shorter loan term, especially if you have poor or fair credit. With a larger down payment, you become less of a risk for lenders, and they can afford to give you a better interest rate. And that also means you pay less interest over the life of the loan.
Better Chance of Loan Approval
Having a substantial down payment can greatly enhance your chances of being approved for a car loan. It also allows you to qualify for a more expensive vehicle. Lenders look at your overall debt-to-income ratio when deciding whether to approve a loan and for how much.
By reducing the amount owed through a down payment, you also reduce your monthly payments, giving you the opportunity to qualify for a higher-priced car.
For example, you may have your eye on a vehicle with a monthly payment of $450, but you only meet the qualifications for a loan with a monthly payment of $420. By making a bigger down payment, you lower the amount that requires financing, allowing you to decrease your monthly payments to the appropriate amount and secure the loan for the car you desire.
Lower Monthly Car Payments
As discussed above, your monthly payment will be lower with a down payment. The total amount paid will also be lower because you won’t be paying interest on that portion.
Making a down payment on a car also provides you with added equity in the vehicle. This is crucial in the event of a total loss due to a car accident, as you won’t owe more than the car is worth.
Furthermore, a down payment can help mitigate the impact of the first year’s depreciation, especially with a new car. This is because they often experience a significant decline in value once they leave the dealership. By putting money down upfront, you can avoid finding yourself “upside down” on the car, where you owe more than it’s worth.
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How much should you put down on a car?
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 car 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 auto loans varies. It’s based on several factors. However, it’s usually best to put down as much as you can afford.
Your Credit Score
Your credit history is the key factor in determining the size of the down payment required for your car loan. A pristine credit profile could mean you only need a minimal down payment, or none at all.
On the other hand, if you have a low credit score, you may be required to make a larger down payment to secure financing. However, even people with poor credit can often obtain an auto loan if they can put down a substantial amount.
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 frequently offer special promotions claiming “no down payment required” to attract customers who may not have extra cash on hand. As an alternative, they may also accept your current vehicle as a trade-in, using it as a form of down payment.
In such cases, the dealership may not have strict requirements on the amount or percentage of the down payment, as long as one is provided.
Remember that the amount needed for a car 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 an auto loan if you can come up with a certain dollar figure for the down payment.
Why a Larger Down Payment is Better
While no-down payment offers might sound tempting, especially if you’re lacking trade-ins or cash, they aren’t always the best choice in the grand scheme of things.
Putting a larger amount down on a car loan leads to smaller monthly payments, reducing your chance of falling behind on payments and potentially facing default.
Furthermore, a down payment helps to lower the amount you owe on a car, reducing the risk of owing more than the car is worth in the event of an accident where the vehicle is deemed a total loss. Car insurance companies will only pay the amount equal to the vehicle’s current value unless you have gap insurance. So, if you owe more, you’ll still be on the hook for the remaining amount.
This balance can sometimes be rolled into a new loan if you purchase another car, but without a down payment, you’ll end up owing even more on a new vehicle than it’s worth.
The Importance of Saving for a Down Payment
When it comes to buying a car, you need to start planning for a down payment right away. Even if you have a car to trade-in, this alone might not be sufficient to meet the 20% mark favored by many lenders. A smart strategy would be to supplement your trade-in with cash saved specifically for this purpose.
An effective approach to purchasing a vehicle is to focus on the amount you have available for a down payment. Instead of searching for a car you like and crossing your fingers that your down payment will be enough to secure financing, it’s best to begin by determining the funds you have to put down.
Suppose, for example, that you’ve managed to save $1,500 for a new car. In that case, you could consider cars priced between $7,000 and $8,000 to ensure you have a 20% down payment. Although new cars at this price point might be scarce, the same principle applies if you plan to finance a pre-owned vehicle.
If you have a trade-in vehicle worth $3,000, you can now explore cars with a price tag above $20,000. Keep in mind, it’s always wise to start with the funds you have readily available rather than browsing cars with the hope of a lower down payment being enough.
Is a larger down payment the best choice for all purchases?
Usually, the answer is a resounding “yes.” But there are times when opting for a smaller or no down payment can make more sense.
For example, if interest rates are at a low, it might be more beneficial to invest your money. To make this decision, you need to determine if the return on your investment will surpass the cost of financing the car.
To find out, you’ll need to calculate both your return on investment and the number of monthly payments under both scenarios (higher and lower down payments). If the difference is less than your potential investment earnings, then going without a down payment, or with a smaller one, may be the way to go. Utilizing a loan or payment calculator can assist with these calculations.
Putting money down on a car isn’t just a necessity for securing most car loans, it’s also a strategic financial move that can save you big bucks. Grasping the significance of saving for your dream ride not only helps you attain the car you truly desire, but also lowers your monthly payments.
By recognizing the worth of investing in your vehicle, you’ll find it easier to prioritize savings before you hit the car dealership.