Some consumers will spend days making sure they get the lowest price on a vehicle, yet they won't bother to shop for the best auto loan. If you don't have financing in place when you visit the dealership to buy, you're leaving yourself vulnerable to whatever terms the dealer offers, which may have a much higher interest rate than you could get elsewhere. And dealers often mark up the interest rate of a loan over what you actually qualify for, which can cost you hundreds of dollars extra.

Ultimately, you want to balance a loan's total cost against a monthly payment you can afford. But if you concentrate only on the monthly payment, you'll increase the chances that you'll unknowingly end up with a bad deal. It's also smart to face reality before setting your sights on a dream machine. For more information, read "How Much Can You Afford to Spend on a Car?"

Keep an Eye on a Loan's Total Cost

When comparing auto loans, the figure to focus on is the annual percentage rate (APR), which varies from day to day. A lower rate can produce significant long-term savings. For example, a three-year, $15,000 loan at 5 percent APR would save you almost $500 overall compared with the same loan at 7 percent.

Another key consideration is the term of a loan, which can significantly affect both your monthly payment and the total cost of your financing. A shorter term means higher monthly payments but less money paid overall. Try to keep the length of the loan as short as you can afford.

A three-year loan costs far less overall than a five-year loan. For example, if you borrow $15,000 at a 6.5 percent APR for 36 months, your monthly payment will be $460 and the total interest will be $1,550. The same auto loan stretched out to 60 months would lower the monthly payment to $293—more than $150 less—but increases the interest by $1,060 to a total of $2,610. And that doesn't even take into account that longer loans often have higher interest rates.

Another concern with long-term auto loans is that they lengthen the time before your payments begin building equity in the vehicle. For example, with a 60-month loan, it might take 18 months of payments or longer before the car is worth more than you owe on it. This means that if you want to trade in or sell the car early, the price you'll get won't cover the amount you still owe, also called being "upside down." The same is true if the car was stolen or destroyed. Your insurance payment won't be high enough to pay off the rest of your loan.

You can reduce this period by taking a shorter auto loan. For example, with a three-year loan, you already might have built thousands of dollars of equity in the vehicle by the end of the first year.

You can avoid being upside down by making a significant down payment. When financing the purchase of a new car, we recommend having a trade-in or down payment of at least 15 percent of the total cost.

Where to Shop for an Auto Loan

The auto-finance business is enormous, with hundreds of institutions making hundreds of billions of dollars' worth of car loans every year. The largest lenders are national banks, such as Bank of America, Capital One, and Chase. Other big players are the "captive" finance companies belonging to automakers, such as Ford Motor Credit, Honda Finance, and Toyota Financial Services.  

Some of the best deals come from those captives, especially when the automaker itself is subsidizing the loans. Other lenders include credit unions, local banks, and finance companies. Consumer finance companies are not banks—they don't take deposits—and many of them specialize in making high-interest-rate subprime loans. They include Westlake Financial, Credit Acceptance Corp, and Santander, an international bank that has a large consumer-finance division in the U.S.

Here's a rundown on various types of lending institutions:

Banks generally have very specific, conservative loan policies, and some of them may cater only to those with better credit standing. As such, they are in a position to offer some very competitive loan rates. Bank offerings vary tremendously, though, and some banks are more interested than others in making loans to people with marginal credit.

Because you probably have a relationship with at least one bank already, a local branch might be a good place to start. Most banks have websites where you can check their current auto loan rates, but if you decide to apply for a loan, you should stop by a branch office and deal with a real person. It's a good way to control where your personal information goes, and by avoiding mistakes or misunderstandings, you might walk out the door with a pretty good offer. 

Credit unions operate a bit like banks, but they are usually nonprofits owned by their depositors, with lower operating costs than banks. That lets them lend money at lower rates than banks charge. Many credit unions lend money only to their members. However, some make loans to people who don't have deposit accounts with them. The website Credit.com maintains links to several big credit unions that make loans to the general public.

Online lenders can be competitive and also very convenient to use. Sites like Clearlane, E-Loan, and LendingTree farm out your request to numerous lenders, netting you several offers. Individual lenders like Capital One also have online loan operations.

Online financing has a downside, however. It may be difficult to control where the information you provide about yourself goes, and you may be bombarded with email and phone calls from lenders you never heard of or contacted in the first place.

If you do make an online application, be sure to check for any upfront fees. Also back away from an auto loan with prepayment penalties that would make it hard to refinance if you want to in the future. And be sure to check each website's privacy policy before providing personal information. As a precaution, if you're not familiar with the lender, check out its site with the Better Business Bureau (bbb.org).

Dealerships arrange auto loans from automakers but also work with banks and other independent sources. One benefit to arranging financing through a dealer is convenience. But the rates they quote often include a markup for the dealership itself, which can make these loans expensive. Armed with offers from some of the other sources we've mentioned, you may be able to negotiate the dealer's initial quote down to something attractive. But you must do your homework first.

Getting Pre-Approved

There are many advantages to shopping around for auto loans and lining up financing before striking a deal on a car.

The first is that loan shopping gives you the chance to compare the various interest rates on offer. Those interest rates can vary a lot from one lender to another, regardless of your credit standing. All of the auto loans granted by Bank A may be more expensive than the auto loans granted by Bank B. The wider you cast your net, the better chance you have of landing a bargain.

Second, getting pre-approved buys peace of mind. You may or may not have found the best deal possible, but at least you know you will have enough money to cover the purchase, and you know the interest rate and term, in years and months, of the auto loan.

To get pre-approved, you first need a pretty good idea of what your new car will cost, including taxes and fees. Deduct the down payment to see how much you'll actually need to borrow.

Once you get approved for some amount, say $25,000, then the lender gives you a blank check good for any amount up to that limit. If it turns out that you find a better deal elsewhere, such as through the dealer, then you return the check, literally or figuratively. There may be fees involved, though, so read the fine print first.

Scary finance fact: Each time you apply for new credit, it lowers your score a little, for a limited period of time. But credit bureaus treat a cluster of auto loan applications occurring in a short period as a single application rather than several, and the negative affect is minor and short-lived. So keep all of your applications confined to a short time period, about two weeks or less.