If you are car shopping, it's a good idea to get pre-approved for a car loan before heading out to the dealership. That has always been Edmunds' advice, and it's as sound as ever. With a pre-approved loan offer in hand, you can quickly decide whether the finance rate the car dealership offers you is the better deal or not.
Being pre-approved means you're free to focus on the price of the car and make sure you're getting one that best suits your needs. And since a pre-approved shopper already knows the loan's repayment terms, there is no need to get caught up in lengthy payment negotiations that take place at some dealership showroom negotiation tables.
But if you have less-than-platinum credit (and a lot of us are in that situation) there's a snag: It's not always easy to find out your actual interest rate. To do so, you may need to have your credit run, and that's usually done with what's called a "hard" inquiry, which can create new problems. Read on to see why and to learn about "pre-qualification," which may be a better way to go.
A Problem With Pre-Approval
If you have top-tier credit, usually meaning a FICO score of 700 or better, you may not need to have your credit run to know what interest rate a credit union or bank will offer on a car loan. Top-tier credit will almost always get the lowest interest rate and a visit to a credit union's website or a quick call to a bank is all it takes to find out what that is. Once you know your interest rate, figuring out a payment using an Edmunds calculator is a snap.
But it's not as snappy for the borrower whose credit is not tip-top. Rates for second- and third-tier credit scores are almost never advertised, so anyone whose credit is fair, average or good — but not quite excellent — has to guess at what the loan's annual percentage rate will be. The only way around that is to let a potential lender run a "hard" credit inquiry.
Some car buyers find that worrisome, for good reason: If they've recently had other hard credit inquiries, one more could result in an immediate drop in a credit score, putting a good loan out of reach.
Hard vs. Soft Credit Inquiries
Hard inquiries are what lenders use when you apply for a loan or credit card. This inquiry will stay on your credit report for up to two years. A single inquiry will likely shave 2 to 8 points from your score.
A couple of points shaved off your credit would normally not be a big deal. But some people seeking pre-approved car loans report that their scores have reduced as much as 50 points because of multiple hard inquiries. Such cases aren't the norm, but the even a small drop is trouble for shoppers whose credit score is on the bubble. The loss of just a few points can be the difference between qualifying for a loan with a low APR or one whose rate is considerably higher.
During the dozen years I sold cars, I saw plenty of shoppers miss out on good financing because their score was 7 to 10 points below the acceptance threshold for a particular credit tier. As a consequence, these shoppers had to pay hundreds and sometimes thousands of dollars in extra interest over the life of the loan.
On the other hand, there's the "soft" inquiry, which is a credit check that takes place apart from an actual loan or credit card application. An example would be an employer checking your credit before offering you a job or an insurance company checking your credit before offering you a coverage quote. These inquiries will show up on your credit report, but they won't affect your score.
Pre-qualification to the Rescue
The good news for car shoppers is that soft inquiries are what lenders use in the process of pre-qualification. Pre-qualification is becoming popular in the credit-card world and is slowly starting to show up in auto financing. Capital One, for example, offers car shoppers pre-qualification for an auto loan and advertises that the inquiry won't affect your credit score. This approach will let you preview a loan rate and calculate a car payment without losing credit-score points, as you would with a pre-approval and a hard credit inquiry.
Another lending source that uses soft inquiries are "peer-to-peer" lenders, which offer unsecured personal, student and auto loans that are often funded by individuals or groups of individuals as investments. Lenders such as Prosper, Lending Club and Upstart offer car shoppers pre-qualification for loans that can be used for auto purchases. These non-traditional lenders also say that their inquiries will not affect a potential borrower's score, and so represent another way for borrowers with less-than-perfect credit to know where they stands in terms or APR and payments without a hard inquiry. Peer-to-peer lenders handle pre-qualifications online, and applicants can expect to have a result back in just a few minutes.
Do keep in mind that peer-to-peer lenders' loans may include origination fees, which most auto lenders don't charge. Should you choose to use a peer-to-peer lender to finance your next car, be sure to factor the origination fee into your calculations.
Another Option: Bring Your Own Report
If you don't want to get pre-approved, pre-qualified or guess their interest rate, there is a fourth option: Run your own credit report and take it with you to the dealership. The Federal Credit Report Act (FRCA) requires the three credit agencies — Equifax, Transunion, and Experian — to provide you a free credit report once per year. This report won't include your score, however: The agencies will charge an additional fee if you want that, so have a credit card ready.
Getting your report only takes a few minutes once you've logged in, and since this is a soft credit inquiry, it won't hurt your score. Once you've accessed your report, be sure to print the whole report (not just the summary) and spend a few minutes with a finance or sales manager. The manager should be able to tell you what rate you'd qualify for on the spot.
To find a dealership that knows how to treat shoppers right, please visit Edmunds.com's Dealer Ratings and Reviews.