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How to avoid overpaying for your car loan

Americans are shouldering a record amount of auto loan debt, and many are taking on bad loans—either because they don’t see the red flags or they feel they don’t have another option.

Americans owed a record $839.1 billion in outstanding auto loan balances at the end of the second quarter of this year, compared with $751.1 billion the same time a year ago, according to Experian Automotive. The sheer number of loans also grew to 61.6 million from 57.8 million a year earlier.

But while consumers tend to be educated about how to research the fair price of a car, many remain clueless about how to get the best auto loan, said Ira Rheingold, executive director of the National Association of Consumer Advocates.

“People don’t realize dealers make more of their profit these days on the financing,” he said. “You really need to shop for the loan before you shop for the car.”

Read MoreNew study says most can’t afford used cars

One approach recommended by financial advisors is the 20/4/10 rule: put down at least 20 percent in cash or trade-in value; keep the life of your loan to four years or less; and keep your monthly payment below 10 percent of your monthly income.

But before you even set foot in a dealership, make sure you know your credit score and try to obtain financing from a bank or credit union. (The Federal Trade Commission provides an extensive guide to understanding vehicle financing, which includes worksheets to help consumers determine how much they can afford to borrow and what to consider when choosing a creditor.)

Without a loan in hand, you’re more likely to get stuck with an auto loan markup, which allows the auto seller to inflate the rate offered by a third-party lender. “This practice alone adds $25.8 billion in hidden interest over the lives of many car loans,” according to the Center for Responsible Lending.

“Yo-yo” sales can also trap a buyer. That’s when a dealership calls after someone has already signed the paperwork and taken the car home to announce something was wrong with the “conditional” sale. Sometimes the dealer will demand the car be returned and the buyer sign a more expensive loan or face consequences.

“Usually that’s a lie,” Rheingold said.

If a consumer gets a call from an auto dealer saying the contract wasn’t really a contract, they should report the incident to the state attorney general and FTC. But the best bet may be to just return the car and go somewhere else, said Rheingold.

Other red flags to look for include fees you don’t understand or charges for items you didn’t agree to like credit insurance.

Read More5 tips to get the best deal on a car loan

As the overall number of auto loans rise, lenders’ tactics are coming under increased scrutiny. The Consumer Financial Protection Bureau, a watchdog agency set up as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, is seeking to extend its supervisory role to nonbank auto lenders (so-called captive lenders) like Toyota FS, Ford MCC and Honda Finance. The proposed plan, which was announced Sept. 17, is currently in a public comment period.

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How to avoid overpaying for your car loan

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