Like mortgage lending, auto financing got tougher after 2008, especially for those with low or no credit. Many Americans held onto their cars rather than upgrading because they couldn't get financing or worried about taking on an auto loan amid layoffs, hiring freezes and other uncertainty.
But as the economy has improved in many parts of the country, auto lenders have loosened the reins and expanded access to financing. That's the good news. The not-so-good news, if you have credit issues, is that you'll often pay a premium for financing to cover the lender's heightened risk just as you would with a mortgage or other loan. Underwriting criteria varies by lender, but in general, you're considered a subprime borrower if your FICO score is 660 or lower, you've had a bankruptcy in the last five years or your debt-to-income ratio is 50 percent or higher.
Errors on your credit report could result in a higher interest rate or even a denied loan application, so check your credit report and dispute any mistakes. A Federal Trade Commission study from last year showed that 5 percent of American consumers had errors on their credit reports that could lead to them paying more for auto loans or insurance.
For people without errors on their credit report, those issues can cost money, too. "If the going rate was 4 percent for somebody with good credit, then somebody with challenged credit might be paying a third more," says Jack Nerad, executive editorial director for Kelley Blue Book, a vehicle valuation and information website.
Here's a look at options for people with credit issues:
1. Pay cash. If you can save up enough money to pay for a car in cash, you'll avoid potential cash flow issues that could lead to a repossession and damage your credit further. "Oftentimes with a credit-challenged person taking on a car loan, [he or she is] looking at something that's beyond their means and can just be a further financial trap for them," Nerad says. This isn't a realistic option for everyone, but if you can make it work, you'll also avoid the higher interest charges you may be offered due to credit issues.
2. Consider the length of the loan. If you must finance a vehicle, set a monthly payment amount that isn't going to stretch you too far financially and balance that with the length of the loan. Longer auto loans -- some borrowers finance a car for six years or longer -- mean you could be underwater for much of the loan, owing more than the car is actually worth due to depreciation. You'll also pay more in interest over the life of the loan but have lower monthly payments. "Depending on the lender, lenders that interact with subprime creditors may require a buyer to take a shorter-term loan in an effort to reduce their risk exposure," says Mike Schenk, chief economist for the Credit Union National Association.
[Read: The Hidden Costs of Buying a Car.]
3. Shop around for financing. Don't assume that with bruised credit, your only option is a dealer willing to finance you at a painfully high rate. Before you enter a dealership, check with local banks or credit unions. Schenk urges buyers to shop around and try at least one credit union, especially if they have an existing relationship with one. "Credit unions are member-only financial cooperatives, and they're smaller than other financial institutions," Schenk says. "They tend to be a little more flexible in their underwriting and be more willing to listen to your story. The fact that they're small means that underwriting is being written locally, not by some big corporation three or four five states over." Also consider revisiting your options in a few months if you can't secure a loan now, as your credit picture may have changed, especially if you were previously out of work. "If you were newly hired, it's conceivable that what looked like not such a great credit score a while ago looks like a good score today," Schenk says. A middling credit score with higher income and a track record with the same employer is more attractive to lenders than that same score without a strong income and employment history.
4. Get a cosigner. If someone like a parent or spouse is willing to cosign your auto loan, it can help boost your attractiveness to lenders. "[A cosigner] gives the lender some options in recovery that are beyond the person with bad credit, so that can help significantly," Nerad says.
5. Find a "buy here, pay here" dealer. If all else fails and you really need a set of wheels, a "buy here, pay here" dealer may be your last stop. "When they really tightened up lending practices, a lot of dealers found themselves in a bind because they had subprime customers and we saw the emergence of this new sales channel: 'Buy here, pay here,'" says Eric Lyman, vice president of industry insights at TrueCar.com, a car-buying website that partners with dealers and offers pricing estimates. "Buy here, pay here" dealers are typically independent dealers that underwrite the loan themselves at a high interest rate, and most have borrowers drop off payment rather than wait for a check in the mail. "You can take delivery of the car, but you're going to have to drop off payments on a regular basis," Lyman says. "It's obviously inconvenient to drive by the dealership and drop off a check, but if you can't get any other options, this could be your last resort."