How to Get a Car Loan When Credit's Tight

by Dawn Handschuh, Personal Finance Writer   

Car dealers are eager to make a deal with buyers these days — incentives and discounts are plentiful — but tighter credit means you'll need a strong credit score and a bigger down payment to drive that vehicle home.

Cash may be king now, but most consumers don't have enough to pay the full purchase price of a new car. So before you go for a test drive, take these steps to secure the financing you need despite stricter lending standards.

Borrower, know thy credit

It can't be over-emphasized — order your credit report and score before car shopping. Ideally, you'll have at least a few months to build a stronger credit history (if you need to) before any purchase.

According to Edmunds.com, banks, credit unions and car dealers categorize borrowers into "tiers," or ranges, of credit scores. These rankings determine what interest rate a given borrower will pay. The most desirable tier is reserved for borrowers with the highest credit scores. In this tier, the average cost of an auto loan — whether at a credit union, bank or car dealer — would be substantially less than the average cost available to borrowers with lower credit scores.¹

If you have time before making your car purchase, you can take steps to boost your credit score, possibly enough to qualify for a higher credit score tier and its corresponding lower interest rate.

One of the most important things you can do to improve your credit history is to continue making on-time bill payments of all credit accounts, loans and utility bills. Your bill-paying history, which accounts for 35% of your credit score, is reported by lenders and other companies that extend consumer credit to the credit-reporting bureaus. This is the information the bureaus rely on to determine your credit score.

In addition, don't max out your credit cards. Consumers who use a lower percentage of their available credit lines have higher scores, so be sure to pay down outstanding balances on credit cards. For related reasons, don't close out credit card accounts, especially the older ones, since doing so would reduce your total available credit. Having access to more unused credit puts you in a better light with car lenders since it demonstrates a restrained, disciplined approach to spending. To avoid having your credit cards closed by the issuer due to inactivity, make sure to charge just a small amount to each of your credit cards a few times a year.

Get pre-qualified

Lock down financing first; if you pick out the car beforehand, you may cave in to a mediocre deal just to get the car home. Shop around for a good rate online, or turn to smaller, local banks, many of which avoided the subprime loan debacle. Being pre-approved gives you greater negotiating leverage at the dealership.

Cough up more cash

Unless you're in the top tier, be prepared to put down a higher down payment — about 10% more than last year.  (A trade-in makes things easier.) In fact, if you're a subprime borrower and you can manage 30% down (or more), you may qualify for top tier rates. Still, even those with decent credit will need a 10% to 15% down payment.

Forget the 6-year term

Stretching out payments for six or seven years is what led many car owners to become "upside down" on their loans, meaning they owed more on their car than it was worth. These days, expect a three- to five-year term.

On-time car payments can help you refinance later

If your credit score isn't high enough to qualify you for the very best interest rate and you don't have time to work on improving your credit score, you can always finance your car purchase now at a somewhat higher rate and try to refinance at a lower rate in a few years. To make this happen, you'll need to ensure that you never miss a payment and that all your car payments are made on time. This will help improve your score over time and, barring any other unforeseen credit missteps, enable you to refinance your car loan down the road.
It's a great time to buy a car. But only if you really need one.

Footnote

¹ www.edmunds.com  Car dealership rates are based on national averages as of November 6, 2008. Bank lending rates are based on average rates of over 900 lenders as of October 9, 2008. Credit union rates are the average of several prominent credit unions as of November 6, 2008. Today's interest rates, as well as what is considered a "desirable" credit score, may vary.