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What does it Mean to Finance a Car – The 2021 Guide

Americans love their cars. And in order to buy a car, many Americans need to finance them. But, what does it mean to finance a car? Let’s check it.

Americans have embraced the freedom, mobility, recreational and commercial potential of mass-produced cars since the first ones were made by Henry Ford in 1913.

There are 276 million registered cars on the road today. They span every conceivable manufacturer and price, from luxury to basic. They are new and used, ranging from 4 to 16 cylinders in the Bugatti 8.0-Liter W16, plus the newest market in electric cars.

Every American deserves a car. The good news for anyone who wants a car is that there is a car for everyone. It may not be your ideal vehicle, but as used car dealers have advertised for years, “Walk in, drive home.” That’s why 85% of all cars purchased in the second quarter of 2020 were financed on credit.  

This is an extraordinary number, but it illustrates that thanks to a very competitive car financing industry and fintech, financing a car is easier today than ever before. Today, car loans are available from banks, credit unions, online lenders, and auto dealerships.

What You Need to Know to Finance a Car 

Car and mortgage loans are granted to borrowers after a thorough financial examination. Home and auto loans have strict rules regarding your financial history and whether you are a good or bad credit risk. But unlike home loans, people with a poor credit history can get a car loan easier than a mortgage.

This happens for a few reasons: If you have poor credit, usually a credit score under 650, you can get a loan, but you pay a higher interest rate, sometimes as high as 10%. Car loans also are readily available because cars can be repossessed easily.

As seen on TV, there are specially-designed tow trucks, complete with bullet-proof glass, so the driver does not have to leave the vehicle to pull a car out of the borrower’s driveway and return it to the car dealer.  

In contrast, mortgage companies can foreclose on a house, but there are strict laws to follow and the foreclosure process can last many months and will involve lawyers, process servers, and the local sheriff. Similarly, credit card companies can take you to a court or garnish wages, but this is also a timely and expensive process.

Credit Scores Are Important

This makes financing a car much easier, whether you have great credit (FICO scores above 750) or poor credit (scores in the low-700s).  

If you have poor credit, here is what will determine your financing package: 

  • Are you buying or leasing?
  • Your credit score
  • Are you putting any cash down to finance the car?
  • The make, age, and style of car
  • The duration of the loan?
  • The price of the car?
  • Are there prepayment penalties?
  • Can you afford the monthly car insurance premiums?
  • How are you paying for sales tax, registration, documentation fees, and other extras you purchase?
  • When will the car loan be worth more than the car itself at the end of the loan period?  

Financing a New or Used Car?

There is a big difference between your dream car and the one you can afford. Cars are expensive.  As of January 2020, the average cost of a new vehicle was $37,851, according to Kelly Blue Book. This is a significant amount, and it’s the main reason why so many people finance their cars. 

While new cars are great, for many people buying a used car is a very attractive financial alternative. This is because car expenses, including repairs, gas, and insurance, should not exceed 20% of your net income. The actual car loan cost should between 10% to 15% of your net monthly income after you deduct maintenance expenses.

If these projections match your situation, you should consider buying a used car. The good news is that technological and better engineering advances have made used cars more reliable than ever. As a result, many brands maintain a higher used car value. 

Credit Scores Are Important in Car Financing

The higher the credit score, the less risk you pose to a lender.

Your credit score is one of the most important factors in determining whether you will get a loan and how much you will be paying in interest over the life of the loan. Essentially your score is the number that shows how risky you are as a borrower.  

Credit rating agencies use complex scoring models to predict a borrower’s risk level to issue a score. The higher the number, the less risk you pose to a lender. This score applies to the most significant financial deals any adult will encounter, especially when it comes to buying a house, car, or applying for any type of significant loan. 

It’s worth noting that some auto dealers only like to work with buyers who have high credit scores. To attract these buyers, the deal will often offer a low-interest rate. Other dealers specialize in buyers with lower credit scores, but this often involves charging borrowers a higher interest rate and some extra fees to compensate for the higher payoff risk the lender is facing.

What to Negotiate When Financing a Car

  • Put money down. Buyers should make a big down payment to reduce the overall amount of money being borrowed. This reduces the total amount being financed.

Down payments make a real difference.  For instance, if a buyer finances a car for four years at 6% and does not put down a down payment, it will cost $2,000 more in interest alone.  However, if the buyer finances a car for three years at 4%, with a $1,500 down payment, a buyer saves over $1,000 in interest alone.

Short term is key

  • Keep the loan duration as short as possible. Car loans generally range from 36 to 72 months. Most experts suggest taking shorter loans even though they carry a higher monthly payment, but frequently have lower interest payments. Shorter loans also carry lower interest payments. Shorter auto loans also are attractive because cars are depreciating assets. At a certain future date, your car could be worth less than what you owe. That’s why it pays to keep the loan terms as short as possible.  It is true you will pay more in monthly loan costs for a five-year loan versus one for six years, but in six years, most cars, especially minivans, are worth less than their loan balance.

Experts say if you are buying a used car, keep the loan term to 36 months or less. If you are buying a new car, it’s common to enter into a five-year loan. These same experts have also noted that 31% more people from 2009 to 2019 entered into loans longer than six years. While this allows borrowers to buy more expensive cars, with lower monthly payments, it also increases the odds that they will owe more than the car is worth. 

  • Make sure there is no pre-payment penalty. This charge, and all other key loan provisions covering the financing of a car, have to be contained in your Truth in Lending Act disclosure. This is the document that governs the loan.  Read it before you sign any final papers.
  • Trade-ins reduce the total amount of money being borrowed, so you can apply those proceeds towards reducing the borrowed amount. 

Follow This Advice Before You Walk into a Dealership

  • Shop around for the best rate, known as the Annual Percentage Rate (APR), before you enter the dealership. The APR is the loan interest rate, plus any fees or charges that comprise the total borrowing money. You can shop for the best APR online, or by visiting your bank or credit union. This is a critical step since it can save you thousands of dollars over the loan’s duration. It is worth noting that car dealers and auto loan lenders don’t have to offer the best rates available. Finding the best rate is your responsibility.
  • Know your credit score. You can get this number from Experian, Transunion, and Equifax, and it is a critical piece of information for any negotiation.  This is because your score determines the interest you pay over the life of the loan. 

Some auto dealers have their own credit scoring model. This may make it hard to establish a single credit score that applies to all auto dealers. Lenders set the credit score based on your credit, but may also consider the amount of the loan, the vehicle, and its age.  

It also prevents some unethical car dealers from charging you a higher interest rate than your score dictates and what you could get from a credit union or a bank. When this happens, the dealer and the finance company will split the difference into actual monthly payments compared to the lower rate you were entitled to. Review your credit score on a regular basis, so you can remove any erroneous information it may contain. 

Another option is to improve your credit score by paying down debt and correcting any mistakes the report may contain.  Repairing your credit can take a few months, but it is worth it over time.

Avoid These Common Mistakes When Financing a Car

  • Know how to deal with trade-ins. If you want to combine a trade-in with a new car purchase, and you owe money on the old car, be careful. If you roll your debt over (and about one-third of buyers fold $5,000 of old debt into the new loan), it means you are financing old debt on the car you are no longer driving.  This is bad financial planning.  The alternative is to sell the used car, and take that cash and apply it to the new purchase. Otherwise, you are benefitting the lender and penalizing yourself.  
  • Know your credit score. While it’s unethical, some auto dealers will intentionally lower your credit score to charge you a higher interest rate. Dealers are not obligated to offer you the lowest interest rate, so knowing your score is your responsibility.
  • If a car dealer asks for your car budget, do not tell them. This is a common trick. Some dealers do this because interest rates, fees, expenses, and the length of the loan that go into a total monthly car loan payment total can be manipulated to max out your budget.   
  • Negotiate the car’s price and interest rate separately. These are key elements in the negotiation, so do not focus on making this a package as a monthly all-in payment. To get the best deal, the car price and interest rate should be negotiated separately.
  • Beware of expensive add-on services. Buyers often can be lured into buying expensive and unnecessary special features during the purchase process. Some of these unnecessary extras include buying longer maintenance contracts, extra accessories, warranties, even life insurance if the borrower dies. Avoid these extras.  Dealers make a significant amount from their insurance and finance departments as unsuspecting new car owners begin writing checks for unnecessary extras.

Research Your Purchase

While buying a car can be euphoric, it is also time-consuming. When you finally conclude all of your research about financing a car, remember that closing the deal can take hours.  During the wait, review the contract. Review the Truth in Lending Act disclosure papers. Do not rush into signing the final papers. Check for mistakes because once you sign the papers it is difficult to impossible to renegotiate the terms of the entire lending agreement. 

While it can be intimidating, financing a car can be an exciting and memorable event.

–Chuck Epstein

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