Introduction to How Car Financing Works

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­If you've read How Buying a Car Works, you know the car-sales lingo and the ins and outs of negotiating with a seasoned car salesman. Let's say you've battled for the best deal and finally agreed to a price you can live with -- time to breathe a sigh of relief? Not exactly. Did you know that if you finance a new car through the dealership, the finance person is working on commission? That means that the financing deal you get is still up in the air, although they'll never tell you that. Those things that get added on in the final stages of the deal (extended warranties, undercoating, alarm systems, etc.) are often what the dealership makes the most money on. It's the finance-office person's job to upsell you on those items AFTER you've agreed to a price for the car with the salesman.

In this article, we'll cover the choices you have for financing, what determines the interest rate you get, and how to determine if you're really getting the best deal, as well as some scams to watch out for. We'll even give you a cheat sheet to take with you when car shopping to help you figure out things like whether taking the rebate or getting the zero-percent interest deal is best.

If you're like most people, paying cash to buy a new car just isn't in the realm of possibility. And even if it's in the realm, you may not want to deplete your savings account to buy a new vehicle. This means that you're either going to be leasing the car, or buying the car by financing it. If you're buying, then you're probably financing it through the dealership, a bank or credit union, an online financial institute, or maybe even a family member.

While leasing is good for a lot of situations, it's a whole other animal, so in this article, we're focusing on financing. If you know you want to finance your car rather than pay cash, then you need to do your homework and decide how to get the best financing deal.

If you do have the money to pay cash for your car and are considering doing it, how do you know if it's really the right thing to do? Here are some instances when paying cash really is in your best interest.

  • If you could pay more interest by financing that amount of money than you could earn if you invested it or kept it in a savings account of some sort
  • If you don't have a very good credit rating and would have to pay a high interest rate to finance (more on this later)
  • If you have a lot of debt already but enough cash on hand, and don't want to further damage your credit rating

But if you're like many people, you probably need to finance your car. So in the next section, we'll look at the pros and cons of financing resources and find out how to determine the best rate.

Sources of Financing

There are several different ways that you can finance your car, and there are pros and cons about each of them.
Dealership
  • Pros: Convenient, fast, sometimes competitive
  • Cons: High pressure, usually not competitive; be prepared for a big sales push on add-ons; loans are often front-loaded (payments are made up of more interest in the beginning of the loan than toward the end -- that's bad if you think you may be paying the loan off early.)
Bank or credit union
  • Pros: Competitive rates, personal service, no sales pitch for add-ons; often can tell you if you're paying too much for a car; often provide free life insurance or disability insurance with loans; loans are usually simple interest loans (interest spread evenly throughout the term of the loan)
  • Cons: Not as convenient as dealership financing -- can't set it up at night or on the weekend
Online financial institution
  • Pros: Usually competitive rates, quick, easy
  • Cons: Not a personal service; dealing with an unknown; some scams to watch out for
Home equity loan:
  • Pros: You can deduct some of the interest from your taxes; competitive rates
  • Cons: You're tying your car to your home (may be risky)

Family member or friend

  • Pros: Personal service, easy, sometimes flexible; usually competitive rates
  • Cons: Could jeopardize a relationship

Determining the Rate
The interest rate you get when financing a new or used car can vary quite a bit from the advertised rates you see on TV or read in the paper. Probably the biggest influence on your rate is your credit rating (see How Credit Scores Work to get the full story). Your credit history and credit score tell lenders a lot about your money habits and are designed to give them an idea of what their risk is if they loan you money. They often raise the interest rate if your loan is seen as high-risk.

Another thing that affects the rate you get is the length (term) of the loan. Typically, the shorter the loan, the lower the rate. Keep in mind that the shorter the term, the higher your payments will be.

Used cars will have higher rates than new cars. The newer the car, the lower the rate. (You may find an exception to this rule at some credit unions. Some give the same interest rate for new and used cars.)

Your geographic location can also be a factor in the rate you get. Your cousin may have gotten 7 percent on the other side of the country, but in your home town, 8.5 percent may be the lowest rate you can find.

While these are the usual things that affect the rate you get through a bank or other financial institution, financing through the dealership may or may not actually work this way. Find out why in the next section.

At the Dealership

­ W­hen you finance through the dealership, you have to remember that the Finance and Insurance (F&I) department is often a bigger profit center than the sales department. The business manager (the person you deal with in the F&I department) sends your credit information to the lender(s) they deal with. The business manager then takes the lowest approved interest rate and marks it up (increases it). The marked-up amount is the dealership's profit on the financing. There is no law saying the dealer has to reveal that mark-up to you. This is why you have to keep your negotiating hat on throughout the process! This financing is really just another product the dealership sells, known as a Retail Installment Sales Contract (RISC).

Special Incentives
You're watching your favorite late-night TV show, and between the shampoo and fast-food commercials you see a car ad that offers zero-percent interest or a $2,000 rebate on a car you've been thinking about buying for months. Wow! What a deal! You have to get to the dealership now! So the next day, you do just that.

Factory-to-Consumer Rebates
First, let's find out what those offers mean. With the factory-to-consumer rebate, there really is no catch. These are rebates the car manufacturer offers directly to you as an incentive for you to buy a specific car. They offer them when they see a larger number of that particular car sitting on car lots than they would like to see. So, in order to move the cars off the lots (i.e., get people to buy them), they offer the rebate. The rebates are not part of the dealer's package and shouldn't even come into play when you're negotiating the sales price with the salesperson. Don't let them try to use the rebate as a way of making the purchase price lower. You have the choice of applying the rebate to your down payment (or not). As Michael Royce says on his Web site, Beat The Car Salesman.com, "Take the money and smile."

0% APR
Zero-percent interest? Who wouldn't jump at that? And you should jump at it if you can handle the term. Often (but not always), in order to get zero-percent financing, you have to agree to a shorter term loan, sometimes 24 or 36 months. This means your payments are going to be quite high. Of course, it also means you'll have the loan paid off relatively quickly (compared to the more common 48- to 60-month term). Here are few other things that may come between you and that zero-percent rate:

  • In addition to the usual shorter term of the loan, you have to qualify for that rate. In most cases, if your credit score is lower than 680, you won't be able to get the lowest rate.

  • You may be limited to buying from what's on the lot, rather than being able to order a car with the exact features you want.

  • Know that by going for the low interest rate you usually lose the cash rebate. It's one deal or the other -- not both.

In many cases you're better off taking the rebate and financing elsewhere at a higher rate:


2.9% Dealer Financing
Take the Rebate & Finance Elsewhere
Vehicle Price
$20,000
$20,000
Trade-in Value
$2,000
$2,000
Rebate
$0
$3,000
Amount Financed
$18,000
$15,000
Term (months)
60
60
Interest Rate (APR)
2.9%
5.9%
Monthly Payment
$322.64
$289.29
Total Cost of Loan (P&I)
$19,358.65
$17,358.49


To figure out which is the better deal between taking the cash rebate or the low APR, use this calculator at Edmunds.com. Don't forget to try the same calculation taking the rebate and financing with your bank or credit union. Also, read about How 10% Can Beat 0% at the Consumer Task Force for Automotive Issues Web site.

For a list of current rebates on specific cars, check out Intellichoice: Rebates and Incentives.

Recent Graduate Programs
Many car manufacturers offer a special "recent college graduate" program that gives new graduates a discount on the purchase of a new car. The savings is usually around $400. Each manufacturer may have different rules. For instance, some have rules about excluded models and selecting a car from dealer stock. Be sure to ask about it if you're a recent graduate. (Recent, for most manufacturers, means within the last two years. Double check that when you're shopping.)

The smart thing to do is to visit the manufacturer's Web site before you go to the dealership so you know what special deals are being offered directly from the manufacturer.

Dealer Financing

car window etching

­You're in the "Finance and Insurance" office setting up your financing with the business manager. Your guard is down now that the deal is done, and you're really excited about driving home that new car. Make sure you're not so euphoric ­you forget to use good judgement for things like:

Interest rate, term of the loan, down payment, rebates, and monthly payments: Remember you can negotiate that interest rate (see the next section to arm yourself for this step). Make sure every element is spelled out on your contract and is correct. Don't sign until you're satisfied that all of the numbers have been filled out correctly. Also, make sure the interest rate you are agreeing to doesn't change during the term of the loan, and ask about prepayment penalties. Remember that the bottom line is how much you're paying for the car, not what your monthly payment is. You may be getting a really low monthly payment, but how long will you be paying it? Almost any payment level can be reached if the loan term is long enough. Make sure there is no "subject to financing" or "subject to approval" statement on the contract (see Spot Delivery warning in the next section).

Extended warranties: The business manager will always offer you the extended warranty on your new car. Some experts are of the opinion that the warranties that now come with new cars are comprehensive enough that you don't really need the extended warranty. If you feel you do need it, explore other sources for those warranties so you can compare. You will be able to get a better price (usually half of what the dealer charges), and sometimes even a more comprehensive warranty, by buying one through online sources or through some banks or credit unions.

Rust protection, undercoating, fabric protection and paint protection: The rust protection, as well as the undercoating, is usually already applied at the factory, so there is no need for you to have it done again (and pay for it twice). Check the car's factory warranty to make sure it has a Rust Perforation Warranty.

You can easily apply the fabric protection and paint protection yourself. The fabric protection is usually no better than you could do with a can of fabric protector you can buy at the store, and you can protect your paint with any polymer sealant car wax. Even the paint protection the dealer applies has to be reapplied every six months.

If these things are already on the car, then negotiate the price down to something reasonable. Since there is usually a 100% markup, start at 50% of the asking price for each item. If they won't budge, then feel free to walk out on the deal.

Alarm systems and window etching: Sure, you want to protect your car from car thieves, but with the amount of money most dealerships charge for the system you could hire a guard to watch your car. You can get an alarm system installed at most reputable auto shops that's just as good as the one the dealer would install. This can often save you over $500.

Window etching is when they etch the Vehicle Identification Number (VIN) on all of the vehicle's windows to deter car thieves and help in the recovery of a stolen car. Having the numbers etched on the windows forces the thief to replace all of the windows in order to disguise the vehicle's true identification.

Many insurance companies will give you better rates if your vehicle has VIN etching. Many police departments also recommend it because it makes it easier to trace your car. Now, with that said, do you need to pay the dealership hundreds of dollars to do it? Not really. There are companies that sell the supplies to do it yourself for about $20 or $30, and it only takes a few minutes.

If the car is already etched, it's the same deal as with the other add-ons. Negotiate the cost down to something reasonable. Sure, they took the time to etch the windows and deserve payment for that, but you know the cost of the supplies and how long it takes to do it. Make your offer based on that information.

Insurance: You will almost always be offered life and disability insurance while you're financing at the dealership (often at banks and credit unions, too). Do you need this insurance? Maybe. The idea is to protect your investment in the event that something happens to you. The thing to remember is that there is no requirement that you get it even if the business manager tries to imply that there is. You should also be on the lookout for this insurance being added without your knowledge. You can get much better rates elsewhere for this type of insurance, and banks and credit unions sometimes include it free of charge if you finance your car with them.

Read on to find out about additional ways that the dealer may try to up your total cost.

Buyer Beware

Here are some things to watch out for when you're purchasing a car at a dealership:

  • Spot delivery: Many of us have never heard of spot delivery. What happens is that the dealer takes your down payment, tells you the amount that your monthly payments will be, and sends you home in the car. What hasn't happened is a final contract. Before your permanent tags and payment book are sent out, you may get a call saying the financing they thought you were going to get didn't go through (as if they didn't know your credit score when they sent in the paperwork). You'll have to either bring the car back or sign a new contract, sometimes pay more on your down payment, and always have a higher monthly payment. It can be a nightmare! ALWAYS make sure you are signing a completed contract and every detail is approved and included accurately. Watch for the "subject to financing" statement.
  • Additional Dealer Markup (ADM): These charges can include many of the items we mentioned above such as rust proofing, undercoating, VIN etching, as well as dealer prep and other fees. Dealer prep can be $500 or more for something that takes the dealer two hours to do. Always negotiate these costs if they're included in the deal. None of them are written in stone -- even though the dealer may want you to think so by preprinting them on the form.
  • Credit reports even if you're paying cash?: Don't let people run your credit report unless you think you're going to be financing with them. Every time your credit report is run, your credit score can decrease. Some dealerships may say it's their policy to always run a credit report on potential buyers -- even those paying cash. Don't let them. They will sell you a car without it.
  • How much is the total financed amount?: Make sure your down payment, trade-in, and rebates are being applied to the sale price of the car accurately. According to 'Lectric Law Library: Auto Dealer "Swallowing" Of Customer Downpayments, Trade-Ins, And Rebates, there have been many instances of these dollars disappearing (usually into dealers pockets).

Why You Should Shop for a Loan

­To avoid having to deal with the potential scams and high costs of financing through the dealership, you may want to explore all of your financing options before you get to that point. By preparing yourself with good information and knowin­g what your options are, you can make a much better financial decision. Don't let the excitement of driving off the lot in that new car distort your perspective on things and cloud your judgement. That's just what the salesman wants!

Before you start shopping for cars, you should shop for the money to buy a car. Before you can shop for the money, however, you have to figure out how much of a car payment you can afford to pay each month. Once you know how much you can afford, use one of the hundreds of online car payment calculators to find out what that total car purchase price can be. You'll need to know the current average interest rates for car loans before you can calculate that, so also visit an online banking site to see what the best interest rates are at the time.

Here is an example of how this would work. Let's say you've looked at your budget and know you can afford a monthly car payment of $300. You've also looked at interest rates and see that the average rate is around 6% right now. If you know you are willing to pay that $300 every month for the next five years, then, calculating backwards, you'll know to look at cars that cost around $13,000. Try this calculator if you don't want to have to figure out your budget first.

By approaching the car buying monster from this angle, you can more easily end up with a car you can afford (even if you don't end up with the car you've been fantasizing about). Still, this is the smart way to go about it. Don't wait until you're at the dealership, talking with the salesperson, to figure out the total car price you can afford. Of course, that's what they would like you to do; and they only want you to think about that monthly payment, because they can always stretch out the term of the loan to get close to the payment you want to make. Plus, remember the funny thing about perspectives. As a buyer, when telling the salesman you want a payment around $300 and no higher than $350, you know you're leaning toward the $300. The salesman, on the other hand, hears only the high number.

Now that you know why it's important to get a loan first, read on to learn how to shop for a loan.

Loan Shopping

­The first place to start is with your own bank. Always check out their rates and over­all loan costs. You already have a relationship there, and you may get the best deal as a result of that relationship.

Credit unions are also a good place to shop for loans. Credit unions usually have lower operating costs and can offer lower interest rates as a result. You may have to be a member, however.

Both banks and credit unions will be happy to go over the details of the loan, give you an idea of the price you can afford, as well as tell you whether or not the price you've been quoted is a good one. Take the information they give you to the dealerships when you're shopping so you have it to compare to the dealership's financing offer.

Also keep in mind that, if you're a homeowner, your best bet may be to get a home equity loan and buy your car with cash. You'll be able to deduct some of the interest you pay and may also get a better rate than you could on an auto loan. And no matter what, be sure to check online banking sources. Reputable online lenders can often save you tons of money on your overall car purchase.

Remember, while there can be high pressure and some scams to watch out for when you finance through the dealership, that doesn't mean you can never get a good deal there. Sometimes you can. You just have to be alert to what they're really telling you (or not telling you) and make sure you're getting the deal you think you're getting. If they can beat the best financing deal you can get elsewhere, then go for it.

Go to the next page for a "Cheat Sheet" of the most important things to keep in mind when financing a car.

Cheat Sheet

­ ­We've put together the most important information from this article in the form of a "cheat sheet" you can take with you when you go car shopping. First, we'll start with the top 10 things to do both before you go to the dealership and while you're there, and then we'll go over some terminology.

  1. Get a copy of your credit report and correct any errors that are lowering your credit score (errors in credit reports do happen -- probably more often than you think).
  2. Have a copy of your accurate credit report with you when setting up your financing at the dealership.
  3. Know the MAXIMUM amount you can spend on the car -- not just the monthly payment, but the actual car price.
  4. Visit the manufacturer's Web site to see what special incentives, rebates, or other deals that you may be able to take advantage of. Many of these are available whether or not you finance at the dealership. Print them out so you're armed when you're negotiating with the dealer.
  5. Visit Kelly Bluebook or Edmunds to find the value of your existing car if you plan on trading it in. (You might also visit your mechanic to get a list of repairs the car needs and their associated costs so that when the dealership tries to deduct money for those repairs, you will know what a fair amount is.) If the dealer won't give you a fair price for your car, then don't trade it in -- sell it yourself.
  6. If you know which car you want to get, go to the manufacturer's Web site and print out all of the pricing information so you know what the car should cost with the features you want. Take that with you to the dealership.
  7. Shop for loans from banks, credit unions, and online financial institutions and take detailed cost and interest-rate information with you to the dealership so you can compare things like the APR, whether the loan is front-loaded or simple interest, application fees, loan terms, and prepayment penalties. Or, go ahead and get the loan and go to the dealership as a cash buyer.
  8. Remember that increasing your down payment with rebate money to lower the financed amount is often a better deal than 0% APR.
  9. Have any rebates mailed directly to you rather than letting the dealership "apply them to your down payment." Take money from your savings to pay the down payment and then replace it when you get the rebate check from the manufacturer.
  10. Finally, don't be afraid that you're taking all profit away from the dealership. Even if they say they're selling the car to you at their invoice cost, they're still making money due to "holdbacks" and other dealer incentives from the manufacturer.

Terminology

APR: Annual Percentage Rate

Backend: Another dealer profit center that includes financing, insurance, warranties, VIN etching, and those other things they try to add to the deal when you're setting up financing

Backdoor money: Additional rebates the dealers get from manufacturers for selling their cars

Factory invoice: The invoice from the manufacturer to the dealer that is supposed to be their purchase price - It's not their actual cost because of holdbacks, advertising fees, gasoline charges, dealer discounts, rebates, and other dealer incentives.

Front-loaded loans: Loans that require payback of mostly interest in the beginning so that the lender gets paid first

Holdback: Money the dealer gets from the manufacturer if he sells a car within a specified time (usually three months)

M.S.R.P.: The total Manufacturer's Suggested Retail Price. This may not include items the dealer has added such as security systems, VIN etching, etc. The total Base M.S.R.P. is the suggested retail price with no options. The total Base M.S.R.P. plus Options price includes all options. Both the Base M.S.R.P. and the Base M.S.R.P. plus Options may still not include additional items that have been added at the dealership (as mentioned above).

Prepayment Penalty: A fee that some loans charge if you pay off the loan before the end of the term.

Simple Interest Loans: Also known as "flat rate interest," simple interest is calculated only on the initial amount of the loan by multiplying the principal balance by the rate of interest by the term of the loan. This number is then divided by the number of months of the loan for the amount of interest paid each month.

Term: The length of the loan in months

Trade-in allowance: The amount of money taken off the purchase price of the new car for the trade-in of your old car

Upside-down Loan: When you owe more on your car than it is worth

For lots more information on car financing and related topics, check out the links on the next page.

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