There has been a tremendous amount of news coverage on the lack of new and used cars to buy in Canada. Since the majority of us need a car to lead a normal life, we are going to take a closer look at how do car loans work.
Our team outlines a few key things to know about how car loans work in Canada when you’re thinking about financing a new car purchase.
Imporant Terms
Annual percentage rate (APR): Let’s start with the most important, interest. APR, Annual percentage rate is what we are all charged on standard interest auto loans. It is expressed as a number, like 5% APR or something similar.
It’s a calculation of the annual rate you will be charged for the auto loan. It is comprised of the Canadian prime rate plus a percentage the lender includes on top as their profit.
The lower the APR number, the cheaper the loan.
Credit history: Your credit history is exactly what it says it is. Your history of managing credit. It’s a record of your financial dealings outlining how you paid them, whether you paid on time and how long you had those debts.
As the lender doesn’t know you, your credit report, including your credit history, forms part of their lending decision. Your credit report will also include how much debt you have, how many types of debt you have and some other stuff.
If you always paid debts on time, your credit score will be high as a result. If you missed payments for any reason, it may be lower.
Negative equity: Another auto loan term that seems to confuse people. We saw a lot of this in the financial crisis back in 2008, but it still crops up now and again.
Negative equity, also known as going upside down, is when the value of the car you buy is worth less than the car loan you used to buy it. It’s mainly experienced when buying new cars when initial depreciation lowers the value of the car but you haven’t paid enough of the loan off to balance it out.
For example, you buy a car worth $35,000 using a car loan of $30,000. The car depreciates by around 30% in the first year, reducing its value by around $10,000. Until you have paid off that amount, your loan amount is higher than the car’s value.
That’s negative equity.
Negative equity is not a bad thing. It only becomes an issue if you need to dispose of the car quickly after buying it. If you’re planning to keep the car, things will balance themselves out over time.
Manufacturer’s Suggested Retail Price (MSRP): This is a guide price for a car, or any item, recommended by the manufacturer. It isn’t written in stone and can be negotiated.
Some manufacturers prevent dealerships selling halo models for less than MSRP for a certain period of time. This is rare and only ever on selected models.
Otherwise, dealerships and customers are free to negotiate what they think is a fair price for the car.
It All Starts With an Application
You will need to fill out an application to determine what type of car loan you qualify for. Broadly, these loans are categorized as prime or subprime.
If you have good credit and a reliable income source, you are classified as prime. Borrowers that have weak credit or hard to verify income will be subprime.
The difference between prime and subprime is the amount of interest you are going to be charged. Borrowers with good credit have access to the lowest interest rates, which means you save more over the life of the loan.
No One Size Fits All Model
There is no one size fits all approach when it comes to car loans. The number of lenders has spiked in recent years and lenders now cater to a specific type of borrower profile.
Whether you are self-employed, retired, have bad or no credit, some lenders are willing to do business with you.
How Lenders Underwrite Car Loans
We will be speaking in broad terms since each lender will have a nuanced approach to loan underwriting. The first thing lenders will want to know about you is whether you are responsible by looking at your credit score.
Lenders want to see a stable and consistent track record of repayment over time. The way they can identify borrowers who meet the criteria is by targeting those with a credit score over 700. The only way to get a credit score that high is by paying your bills on time for a couple of years. If your credit score falls below that goal, you can repair it by making your payments on time and avoiding taking on excessive debt.
When the lender is satisfied that you are responsible, they need to know if you are earning enough money to service the loan. Your payslip or income tax assessments will show the lender how much you are earning.
The lender will perform a calculation looking at your debt to income ratio and if it meets their requirement of 40% or less, your loan should be approved.
Wholesale Vs. Retail Car Loans
The lenders that you see online are retail lenders, this means the interest rate they charge you will be higher than what you would pay if you were dealing with a wholesale lender.
We all can understand the difference between wholesale and retail pricing by visiting a big box versus a mom-and-pop shop, car loans work similarly.
When you go through a local dealership, you will have access to the most competitive interest rates and top-notch customer service. These dealerships do a tremendous amount of business with lenders all across Canada so you will have no issues securing the most competitive terms.
As an added benefit, the dealerships have new cars in their inventory that you can take for a test drive.
If you are seriously thinking about buying a car, even if you have credit issues, then your best option is to visit a local dealership.
For those of you who know that you have a challenging credit situation, please visit Dixie Auto Loans where we have a team of credit specialists ready to help you get approved for a car loan today!