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How Does Financing a Car Work? How-to Guide

In need of a car? Let’s talk about financing a car and how the car loans system works.

The first step is to know how does financing a car work. It pays to know key elements that determine critical parts of the loan since they will determine your monthly payments. 

Learn How Car Loans Work

The loan agreement details are all listed in the finance charge section of the terms sheet.

Like most other loans, car financing has a few essential components. 

Car loans consist of the amount you borrow, the interest rate, length of the loan, finance charge, or terms.  The details are all listed in the finance charge section of the terms sheet. When they are combined, they show your monthly payment to repay the loan.

While auto loans are straightforward about the amount, interest rate, length, APR, and monthly payments, loan finance charges are separate.

Auto loan finance charges are the total fees you agree to pay to borrow the money. This means the finance charge includes the interest and other fees you pay as part of the loan repayment agreement.

Elements of the Car Finance Charge

The most significant element when financing a car is the APR or annual interest rate. The APR is the percentage of the loan principal you pay to your lender annually to finance the car purchase. This finance charge includes interest and any fees for arranging the loan. 

Interest rate is the most significant determinant of the finance charge. Therefore, the lower the rate you get, the lower auto finance charge you will pay.  The finance charge and interest rate must be fully disclosed in the APR, according to the Consumer Financial Protection Bureau and the Federal Trade Commission.

Most loan companies give you a loan based on your specific credit and risk history.  In exchange for this loan, you agree to repay the lender a fixed amount monthly over the life of the loan.

Some lenders will finance up to 120% of the value of your new purchase, including tax and license. Most lenders want you to make a down payment of at least 20% of the purchase price, but this varies by lender and by your credit score.

Shopping for the Right Lender

In 2020, drivers bought about 14.6 million new cars, and about 85% of those cars were financed, according to Statistica.  Loans were made by hundreds of auto loan originators, including banks, credit unions, online banks and lenders, and finance companies owned by the auto manufacturers.

It is not only to understand how does financing a car work, but also who will be your lender.

The lenders are all competitive, and some compete better when applying for a new or used car loan.  For new cars, the car manufacturers themselves often offer the best deals. Alternately, banks make competitive loans, but the best rates go to customers with the best credit scores.

Car manufacturers also make attractive loans because they are subsidized. But like banks, this means applicants with good credit scores get the best rates. If you get a new car loan from a dealer, they may often get a small percentage of the loan boosted by a small increase in the APR. Also, if the dealer is offering a rebate and a low-interest loan, the buyer is only eligible for one or the other.

Focus on the APR

Car financing is such an integral part of the modern dealership system that many car dealers are essentially in the financing business instead of selling cars. Car dealers who make loans can query their lenders for the lowest APR and offer the best rebates to the dealer.

Often, these come in the form of increasing the APR from the lender to the one being charged to the borrower.  On the contract, this will show up as a change between the “buy rate” and the “contract rate.” This difference is the profit to the dealer.  Then, dealers can also make a commission based on the size of the loan. 

These incentives are not disclosed to buyers.  Experienced car buyers know this and say it is better to shop for a car loan before you even begin looking for a car. Like a mortgage, car buyers should get a pre-qualification or a pre-approval car loan letter from their lender. The pre-qualification letter requires a more detailed financial check. This letter states the terms of the loan with a cap on the purchase price based on the applicant’s credit score and other financials.

With this letter in hand, car buyers can focus on choosing the car they like best, and one with the best financial terms. 

Remember, if you know how does a financing a car work, you will be able to identify the ups and downs of any element in the APR and, therefore, the contract.

Critical Elements of the Car Finance Contract

The Retail Installment Sales Contract is the document that finalizes the negotiations about the car purchase.

In basic terms, the retail installment sale is a transaction between the purchaser and a dealer to buy a vehicle. This agreement specifies that you agree to pay the dealer the value of the vehicle, plus interest, over the life of the loan. Other lenders and banks can also buy these loans from dealers.

These contracts vary from state to state, but they should all contain the following: 

  • The vehicle’s specific description;
  • Federal truth-in-lending disclosures;
  • The payment schedule, including the number and amounts of payments;
  • Total of payments;
  • Insurance options;
  • Total sale price, and;
  • Late charges.

Understand the Details of the Car Loan

This contract also has an itemization of the financed amount, including any trade-in allowance, down payment, and the unpaid balance. For new cars, car dealers will often customize a new car by adding paint treatments, hubcaps, etc. There are also pre-delivery service fees, taxes, and an electronic registration filing fee. These fees will also vary widely depending on whether the car is new or used. 

Car dealers also offer gap insurance.  This is optional, and it is a form of insurance for new cars that covers your collision coverage or comprehensive coverage. In the event of a serious accident, this insurance would help pay for your totaled or stolen vehicle up to its depreciated value.

If you are trading in a car, look for a section that lists the gross trade-in allowance payoff amount made by the seller and the name of the lienholder (the lender that holds the title).

Besides learning how does financing a car work, it is also a good thing to know what comes after the signing.

The contract also presents the dispute resolution process, including the agreement to arbitrate.  This means a buyer cannot go to court to settle a dispute.

The seller also has a right to cancel after a certain amount of time, provided they meet certain conditions.  If not, they can pay a daily penalty until the buyer returns the car to the dealer.

Think Before You Sign Any Papers

Importantly, in some states, there is no “cooling-off period.”  If you enter into the car purchase and sign the contract, you cannot cancel unless the seller or car dealer agrees or has a legal reason.  As a retail installment sales contract says in Florida, “You cannot cancel this contract simply because you change your mind.”  This means that when financing a car, the deal is final, so don’t enter into a car purchase contract unless you are sure about your decision.

It is also important to read the whole contract. The back of the contract contains disclaimers from the seller, details about the finance charges and payments, and promises made by the buyer to the seller.  There is also an important section on what happens if the vehicle is damaged, destroyed, or stolen.  Remember, you must make payments in full even if the car gets totaled or is stolen, as long as you owe money on the car.

The Importance of Credit Scores in Car Financing

While comparing the APR is one way to keep your auto loan borrowing costs low, another way is to improve your credit score.

Credit scores determine your creditworthiness. In a consumer society based on credit card purchases and making large loans, businesses want to lend money to people who can repay their debts.  Studies have found that people with bad credit have a higher accident risk, so they pay more for car insurance. Bad credit scores can even determine if you can rent an apartment.

Don’t Forget Expenses and Depreciation

Cars are expensive to operate. The ownership and operating costs are the biggest expenses. In addition, owning a car means paying for insurance, gasoline, repairs, vehicle registration, financing, and most importantly, depreciation.  

The American Auto Association (AAA) found that it costs an average of $9,561 annually to own and operate a new vehicle. Of the expenses listed, the greatest one affecting new cars was depreciation.

The reason is that car loans are very different from other types of loans. Cars depreciate faster.  Carfax estimates that new cars drop in value by about 20% their first year. In about four years, cars drop in value by about 15% annually. This means an average car will be worth only 40% of its purchase price after five years. 

Another bad thing about depreciation is that it is invisible. While the monthly upkeep, maintenance, and repairs are all visible, depreciation is only realized when the car is sold.

Car operating and ownership expenses also vary significantly according to the make and model of the car. The American Auto Association (AAA) and other car magazines, such as Consumer Reports, Kelley Blue Book, and Car and Driver, test and list expenses of many types of cars and trucks. Picking a car with a cheaper maintenance and repair record should be a big factor when selecting a car. 

Understanding how does financing a car work

Getting a new or used car is a big decision for some people. It is essential to understand how does financing a car work and all the edges a car loan could have.

In that line, you will be ready to make intelligent decisions in the process of acquiring your four wheels. Check our guide and other related content we have produced for you.

Because the devil resides in the small print, let’s master it. Got any questions? Let us know.

–Chuck Epstein

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