When financing the purchase of a new car, there are lots of organizations available to help you find money. Banks, thrifts and loans, credit unions, finance companies, car dealerships and the automakers all want the job of providing you with money for your new car purchase. They do this because they will earn interest and fees on the money you borrow and in the case of the automakers, make it easier for you to buy their specific cars.
Anyone can get a loan these days, even people with poor credit histories and very little income. The car market is so competitive that even people normally considered poor financial risks can get a loan -- they will just be charged a higher interest rate for the privilege of borrowing money.
Who Loans Money
In most cases, car buyers deal with financial institutions that take on the transaction responsibility, that of moving the money from their financial institution to the dealership's bank and then creating the loan relationship with the buyer. While there is nothing wrong with this scenario -- it is both commonplace and mature -- it reduces the buyer's control over the financial relationship with the dealership and diminishes her negotiating position. If you don't have the cash in hand at the time you are negotiating and once you decide on the car you want, you still have to go through the financing process at the dealership. That generally is not a pleasant experience and can increase the cost of the car purchase.
What happens is this: the buyer selects a car, the dealership either provides their own financing if they are large enough, uses an automaker's financing (called "captive financing") or an outside financial institution. Some examples of captive finance companies are General Motors Acceptance Corporation (GMAC) and Ford Motor Credit (FMC). In either case, the dealership is paid a commission on the loan. They generally receive between 1 and 2.5 percent. That commission comes from an increase in the percentage of interest the buyer is charged. The more the dealership demands in the way of a commission, the higher the interest payment. Conversely, the dealership may set the rate of the loan, for example 10%, and then sell it to a lender at 9%, making 1% in addition to the profit on the car sale. In this situation, you may not know the lending institution that ends up financing your car purchase and you may find the terms unacceptable. While this is a very important process to go through so that you know the going rate of car loans, it is often time consuming and inconvenient. Unlike mortgages, the savings that may come from finding the best rate may be small. For example, the difference between payments on a 48 month, $20,000 auto loan at 8.50% and 8.25% is just slightly more than $2 a month -- $492.97 versus $490.61.
When borrowing from a lending institution what happens is this: the buyer selects a car and contacts a lending institution, applies for a loan and waits for approval. When the car is to be purchased, the buyer can pick up a check, have money transferred or the lending institution works with the dealership on the transfer of funds. The best preapproval is one where you are handed a blank check with a funds limit and an expiration date.
There are generally fees involved with loans, although not all lending institutions charge them. Each financial institution has their own fees and they vary. Some have few. Some have many. The only way to find out the fees is to ask. Some examples of fees are: application, processing, loan origination and bank processing. All of them are different.
Annual Percentage Rate (APR) is the total cost of the loan including the fees. So while two institutions may charge the same interest rate, their fees may vary and you'll see a difference between the two APRs. Compare APRs when trying to figure out which rate is better since the APR takes the fees into account.
The most common car terms -- length of time money is loaned -- is 36 months (3 years), 48 months (4 years) and 60 months (5 years). The longer the loan term, the more total interest is paid, but the monthly payment will be lower.
From time to time automakers offer super financing deals. For example you may see ads for vehicles with very low interest rates attached, like 2.9 or 3.9 percent (sometimes less). This is an attempt to move cars or trucks that aren't selling fast enough and deplete the inventories. In these cases, the automaker's captive finance company "subvenes," or subsidizes the loan. The buyer pays the low interest rate and the automaker pays the dealership for the vehicle and the loss of interest.
Sometimes the automakers offer a cash rebate in lieu of low-rate financing. Consider whether taking this rebate and financing at a normal rate is more attractive. Often, it is.
Preapproved Financing and Negotiating Power
Another route to take when financing the purchase of new car is to get your loan in advance of the purchase -- that way you don't suffer the humiliation of waiting for the finance manager at the dealership to approve your loan and give you your rate. More important than personal comfort, is that you'll actually have a check in hand or quick access to cash when you are negotiating. (See the NEW CAR BUYING GUIDE New Car Buying Handbook for negotiating tips.) Someone with money has a much stronger bargaining position than someone who still has to haggle over a loan.
Preapproval tells you at what rate and terms you would qualify for an institution's loan, And it can improve your negotiating position at a dealership. However, the preapproval process can be inconvenient at many institutions, requiring you to visit the institution twice -- first when you apply for preapproval and again after you purchase the vehicle when the lender reviews your purchase order and other items prior to paying the dealership.
Gary Miller of PeopleFirst Finance (http://www.peoplefirst.com/em.cfm?id=WMART01) recommends that you get a preapproved loan that gives you easy access to the money to make the purchase. "We eliminate the inconvenience often found in the preapproval process by actually providing our customers with a loan commitment in the form of a blank check. With a blank check, there is no need to come back to us after they find their car. Our customers simply fill in the dealer name and amount, sign the check, and they are done. In effect, we turn our customers into cash buyers." Dave Zeller of PeopleFirst says, "If you have to go back to the bank to get a check after negotiating the car's price, you may lose the deal or at least some ground. The more likely you are to buy a car when you are at the dealership or come in and get the car after negotiating over the phone, the lower the price you can negotiate."
Dave went on to talk about rates and convenience. "Given the small difference in monthly payments based on the small differences in interest rate, consider the convenience aspect of the auto loan you are considering. Look at the convenience of the application process -- can it be done over the phone or Internet, can you apply 24 hours a day, how much documentation does the lender require, how quickly do they make a decision, is it minutes or days, what is the process for closing the loan, what do you have to sign, what documents to you need to provide (purchase order, proof of insurance, etc.), where do you have to go to deal with the paperwork, how is your loan going to be serviced, do you have the option of deducting the monthly loan payments from your checking account, does the lender invoice you each month, provide self-addressed, postage-paid envelopes, do you have 24-hour access to your account information by phone or on the Internet -- there are so many convenience options to consider. Given that you will be making a payment every month for years to come, make the choice for personal convenience."
Shopping for Financing
It is critical to shop for financing in almost every situation, even when planning to use a special automaker incentive rate. This shopping is easy to do and can be done over the phone or online by calling or visiting the web sites of a bank, credit union, financial institution (http://www.peoplefirst.com/em.cfm?id=WMART01) or the automakers. Car loan rates are even advertised in newspapers. The loan shopping process requires you to have to have a pretty good idea of the cost of the car you want (with all the features you'll add and their costs) as you need to know how much money to ask for. Then the financial institution will evaluate your ability to pay the loan based on your other financial responsibilities Ask the following questions and get the answers in writing:
What is the interest rate charged on the loan?
What are the fees associated with the loan? What are they called and how much is each fee?
What is the Annual Percentage Rate (APR)?
What is the total cost of the loan over the term (number of months for which you are borrowing the money for)?
What method do you use to calculate interest?
You can create a grid to compare lending institutions:
Comparative Loan Information
First establish the following information:
Car Price (all costs):
Down Payment:
Amount to Finance: Along the top row, place the institutions you intend to compare:
Company A, B, C, etc.
Down the side, place the following items to compare for each institution:
Interest Rate:
Method:
Fee:
Fee:
Fee:
Total APR:
Monthly Payment:
The grid will enable you to compare each borrowing opportunity to see which one is really giving you the best deal. It will also tell you when you may be over charged and what rates are appropriate to your credit history. The better your rating, the lower the interest rate you will pay as you are a better "credit risk." The more likely you are to pay your loan, the less you will be charged for it.
If you want to research your credit history, you can get one free of charge, once a year from Experian (they used to be TRW) and you can get one whenever your credit is checked by a finance company. Experian's web site is at http://www.experian.com. And, it pays to check your credit history every once in a while. Sometimes there are reporting mistakes that you can correct to more accurately reflect your payment history.
It is important not to take the monthly payment numbers at face value. Two lending institutions offering loans at the same monthly rate can be very different. Each can include fees that other lenders don't charge -- or charge less for -- and the terms may be different. Given the same interest rate, a 48 month loan at $299/month only saves $12.00 over the $399/month loan for 36 months and you'll save a whole year of interest on the shorter loan for only a $100 a month increase in your payment. If you keep your money in a savings account, you'll likely only be earning 3 percent interest. You might as well pay off the car loan faster as the interest rate is higher.
To learn what the monthly payment will be for the specific amount you need to borrow, use the free PeopleFirst loan calculator at http://www.peoplefirst.com/em.cfm?id=WMART03.
Haggling For A Loan
It is possible to negotiate on loans. You can make a deal on the fees as well as the interest rate. This is particularly easy when you have already researched loan rates with a number of institutions and know what you should be paying. The worst possible situation is to go into a car dealership at the time you are ready to buy and not know the interest rate appropriate to your credit history. The research will tell you that the 16 percent rate the dealer is quoting you is way too high because your credit union already told you they would lend you the money at 8.5 percent. Knowledge is everything.
Last But Not Least
There is a unique vocabulary used by the lending industry. Here are some of the words you are likely to hear and what they mean:
Principal: The part of the loan that pays for the car. This will reflect the price you negotiated with all the additional features you choose, less your down payment. This is the amount of money you are actually borrowing.
Interest: The rate you are being charged for borrowing the principal. It will be quoted as a percentage of the principal. There are 3 common forms of interest calculations: Simple, Actual and Rule of 78s.
Simple Interest: The amount charged is based on your unpaid principal balance, the interest rate on your loan and the number of days since your last payment. If you make payments earlier, your principal balance is paid down faster and vice versa. There is no built-in prepayment penalty with a simple interest loan.
Actual Actuarial Interest (or precomputed loan): The monthly payment is the same and the amount of each payment which is allocated to principal and interest is "precomputed" assuming you make your payments on time each month. Paying a few days earlier or later each month does not affect the amount of principal that you owe. There is no built-in prepayment penalty with a precomputed loan.
Rule of 78s: Form of calculating earned interest. The interest is earned faster than in a normal calculation as you pay more of the interest you owe in the early monthly payments than the principal. Essentially it works in a prepayment penalty. Many states don't allow this. Try to get loans that are not computed based on this rule.
Loan Prepayment: Paying off a loan early. Comment: not necessarily a good idea given that many car loans have much lower interest rates attached to them than you can earn with an investment. Use your normal cash flow to earn a higher rate on an investment rather than attempting to pay a car loan off quickly.
Prepayment Penalty: A fee you pay if you pay the loan off early. This is the lending institution's way of taking as much profit as possible. If you pay the loan off early, they are left with cash that isn't earning interest, unless they reloan it. So you are paying for the privilege of giving them more money to loan.
Down Payment: Money you pay to reduce the principal, the money you will borrow under the loan.
Subvention (subvene): The way subvention works is that the finance captives offer the low interest rate loan and the manufacturers subvene or subsidize the captives for making below market rate loans.
