It’s not the zombie at your door that’s sending chills up your spine. It’s your auto loan payment. As dusk settles on your neighborhood, a shrill wail shatters the evening’s peace. Goosebumps rise along your arms as you hurry your way inside, closing and locking your door behind you.…
Applying for your first car loan or refinance loan? Here’s what you need to know.
As someone who’s trending toward 30 (scary), I know firsthand how much you learn in your 20s. We’re introduced to a handful of major responsibilities, such as deciding between health insurance plans, saving for retirement, and paying taxes. I’ll never forget the feeling of calculating the hefty chunk of change that the government took from my first paycheck.
Buying a car is one of those major life responsibilities. And, unless you’ve somehow been graced with financial windfalls, you’ll rely on a loan to pay for your first set of wheels.
So, let’s start by discussing what lenders look for when you apply for an auto loan.
How Do Lenders Evaluate Car Loans for Young Adults?
You can get a car loan in your 20s. It’s not like there’s some unwritten rule or secretly imposed age limit. Whether an applicant is 25 or 45 years old, a lender is going to assess the same financial criteria. In fact, it’s against the law for lenders to use age as a reason to not extend credit or to provide worse loan terms.
The difference is that the older you are, the more likely you are to have higher earnings and financial stability. To assess these financial traits, lenders will evaluate the following.
Lenders will review your credit score and credit history when you apply for a loan. And, unfortunately, it’s easy for young adults to be disadvantaged in this area.
Your credit score doesn’t start out perfect — but it also doesn’t start at zero. You have to build credit over time. If you start off making prudent credit decisions like paying on-time and keeping a low credit utilization rate, you’ll have a better score.
FICO’s credit scoring system ranges between 300 and 850. Your first score will likely fall somewhere in the middle. That’s because you’ll have a couple of factors working in your favor — and a few that aren’t.
Credit scores consist of five components:
- Credit age (35% of your score)
- Credit utilization (30%)
- Payment history (15%)
- Credit mix (10%)
- New credit (10%)
When you first establish credit, you could have a low credit utilization (i.e. the amount of outstanding credit relative to total available credit) and fewer hard inquiries. However, credit age, payment history, and credit mix will likely weigh down your initial score.
If you happen to have bad credit, don’t worry. It’s far from the only factor that lenders consider.
Lenders want to see that you make enough money to meet your monthly payments and repay your loan. To verify this, they’ll ask for proof of income — such as a paystub, W2, or 1099s if you’re self-employed. If you don’t have a job, you’ll have a hard time receiving a loan.
On top of reviewing your employment status, lenders will also calculate your debt-to-income ratio (DTI). This compares your total monthly debt payments (e.g. rent, student loans, credit cards) to your total monthly income (e.g. salary, tips, investment income).
For example, let’s assume your monthly obligations include rent, student loans, and credit card payments. Since you’re applying for an auto loan, that would factor in too.
- Rent: $900
- Student loan: $500
- Credit card minimum: $25
- Auto loan: $400
- Total monthly debt payments: $1,825
Assuming your pre-tax monthly income is $3,650, your DTI would be 50%.
Some lenders don’t impose DTI limits, but you should aim for a DTI below 50% to maximize your chances of qualifying.
Car loans are secured loans, meaning the car serves as collateral. If a borrower fails to repay an auto loan, the lender can repossess the vehicle and try to sell it to cover its losses. In short, lenders will assess the value of your car relative to your loan amount. This is known as your loan-to-value ratio (LTV).
Car (LTV) Loan-to-Value Calculator
For example, let’s assume you purchase an $18,000 SUV, and you elect to purchase a gap waiver and a vehicle service contract. Tack on the sales tax and your total bill (and loan request) rises to $21,000. As a result, your LTV is roughly 117%.
From a lender’s perspective, the lower the LTV, the better. But you can still secure a loan with an LTV above 100% (i.e. your loan is higher than the value of your vehicle). You might have a higher interest rate to offset the lender’s risk though.
How to Know if You’re Getting a Good Car Loan
One of the biggest mistakes you can make as a first-time car buyer and borrower is to not compare rates and terms. It’s easy to settle on the first lender you find and agree to their terms, but that could cost you down the road.
Wouldn’t you want to know if you could get a lower interest rate? Even a percentage point can make a big difference.
Let’s compare the terms of two car loans and see how much you’d save.
The only way to know if you’re getting a good car loan with the best rate is to review the terms of multiple lenders. This comparison process is known as rate shopping. And don’t worry — if you rate shop within the right window of time, you won’t hurt your credit score.
Beyond the dealership from which you might purchase your car, also look at a variety of financial institutions — such as banks, credit unions, and online lenders.
Is It Bad to Get a Subprime Car Loan in Your 20s?
You might be wondering, “What if I rate shop and I realize I’m only eligible for a subprime loan?”
Getting a subprime car loan isn’t ideal, but it also isn’t the end of the world. That said, the answer to this question is somewhat subjective.
If you absolutely need a car and a subprime loan is the only way to afford one, then it’s more understandable. If it’s not an immediate need, it can be worthwhile to work on building credit and improving your overall financial profile before you apply. You’ll increase your chances of securing better terms, a lower interest rate, and a manageable monthly payment.
How Can I Improve My Chances of Getting Approved for a Good Car Loan?
Applying for an auto loan is much easier in the digital age — but that doesn’t mean you should immediately dive into the process. You should have an idea of your creditworthiness, so check your credit report first (for free).
If you’re concerned about qualifying, here are a few routes you can take to improve your chances of getting approved.
If your credit check returns discouraging results, don’t worry — you’re not stuck. The most straightforward way to increase your credit score to pay down your existing debt. Credit cards with high balances are a good place to start. This will lower your credit utilization ratio, which represents 30% of your score.
If high debt balances aren’t the problem, you can take a different approach.
There are loans designed to help improve credit scores, whether you have bad credit or no credit at all. For example, the eligibility requirements for secured credit cards and credit-builder loans are more relaxed than traditional loans. Borrowers can use these loans to make timely payments and build credit.
Consider a higher down payment
The higher your down payment, the less risk your lender takes. Think about it this way: If your new car costs $20,000 and you make a $5,000 down payment, you only need a $15,000 loan. As a result, your LTV will be 75%, which offers your lender plenty of cushion.
This not only mitigates a lender’s concerns but also increases your odds of securing a lower interest rate.
Needless to say, this isn’t a universal recommendation. If you’re strapped for cash, don’t sacrifice your liquidity.
Wait until you’re employed
If you’re a student or in between jobs, consider waiting until you’ve secured employment before applying for a car loan. Lenders will require proof of income so that they know you can afford to repay the loan.
While it’s a bit more subjective, the same principle applies if you have a part-time job or side hustle. Some income is better than no income — but you still have to demonstrate that you have enough earning power and stability to make consistent loan payments.
Get a co-signer
Many young adults can’t qualify for an auto loan on their own. It’s not uncommon to have a parent, relative, or trusted friend co-sign to help you get approved. In fact, according to RateGenius customer data, 80% of students who received approval for a refinance loan had a joint applicant.
Once the loan is repaid, you — and you alone — will have ownership rights to the vehicle.
Keep in mind, the co-signer is equally responsible for the loan. So, if you stop making payments and default on the loan, your co-signer is legally obligated to repay.
When Should I Refinance My Car Loan?
Many 20-something-year-olds have to take out a loan when their credit and overall financial profiles aren’t the best. As you earn more income and make on-time payments, your creditworthiness will improve. However, you don’t necessarily need to do that to save money with a refinance loan.
According to a recent RateGenius study, good credit doesn’t indicate more savings. In fact, despite having lower credit scores as a cohort, Gen Z borrowers saved just as much from refinancing ($77 per month) as Baby Boomers. Millennials did even better, saving $85 per month on their loan payment.
With that in mind, here are four times when it makes sense to refinance your auto loan.
If interest rates are low
Interest rates fluctuate over time. If you happened to get a car loan when rates were high (or at a time when you didn’t have good credit), you could be paying more interest than you need to be. A refinance loan can help you save money by lowering your total interest and/or monthly payment.
For instance, interest rates dropped significantly in March of 2020 as a result of the global pandemic. This spurred many borrowers to refinance at lower rates in order to pay less interest over their loan terms.
If you’re over your lender
While saving money is typically the primary benefit of refinancing, sometimes borrowers want a fresh start with a new lender. A lending relationship is still a relationship. If your current lender isn’t a timely communicator or doesn’t meet your needs, you might be ready to bank with someone else.
If you want lower monthly payments
If you’re struggling to make your monthly car payment, you could use a refinance loan to extend your term and reduce your monthly payment. This will likely increase your total interest over the life of the loan, but it’ll reduce the monthly burden of a steep loan payment.
If the fees don’t outweigh the savings
While most major lenders don’t impose them, prepayment penalties are a common feature of subprime loans. In essence, it’s a fee for paying off your loan sooner than your loan’s maturity date.
Depending on your interest savings, a prepayment penalty could offset the benefit of refinancing. However, if your loan agreement doesn’t include this condition, you’re able to refinance without paying a fee.
Don’t Rush the Process
No matter what route you take to finance your first car purchase, do your research first. This can save you time and money down the road.
In addition, consider getting preapproval. This will give you options (i.e. you don’t have to rely on dealership financing) when you’re searching for your ideal car. Plus, you’ll know your budget ahead of time.