Auto Financing Explained
Buying cars seems to be getting easier and easier, with an increasing number of innovative platforms, especially online, that are all seemingly designed to streamline and speed up the overall process. No matter how we change certain elements of the car-buying process, however, one area remains somewhat complex and even intimidating to some buyers, and that’s the world of auto financing.
Auto Financing – Broad-Strokes Overview
We’ll begin by getting a better look at the big picture of vehicle financing. Broadly speaking, the world of auto financing can be divided into two main “camps.”
- Direct Lending
- Dealership Financing
This is, generally speaking, the simpler of the two worlds. With direct financing, you go to a bank, credit union or other finance company and apply directly for a loan which you will then use to purchase a car from new car dealerships or other sellers.
You and the lender agree on a time period in which the loan will be repaid along with an agreed rate of interest (or “finance charge”). You’ll typically see in the terms a full dollar value of both the amount being financed and the amount being repaid at the end of the agreed period.
Once you’ve secured the amount, you then go to the dealership to choose and confirm your vehicle, sign your contracts with them, after which time you can use the direct loan to pay for the vehicle in full.
This refers to times when you get financing directly from the local car dealership as opposed to using an outside financial institution. You sign a deal with a dealership where the latter agrees to sell you the car and allow you to take it away, and you agree to pay an agreed monthly amount over an agreed period of time, usually 36-48 months.
The car dealership may manage the contract themselves, especially if they have their own financing wing as some do, e.g. Toyota. Alternatively, they will sell the contract to a bank or finance company who then facilitates your loan and collects payments from you.
Which is Better?
From this surface glance, it’s hard to say fairly which one is really better than the other. Each has their own benefits and drawbacks:
Benefits of Direct Lending:
- You can compare shops, visiting different lenders to see who can give you the best car deals. This means you ultimately have more options from which to choose.
- It allows you to know your budget in advance (when pre-approved – see more below). When you know already how much a lender will give you, then you can easily create and stick to a budget.
- You also know all the credit terms in advance. You won’t be surprised by any dealership small print or sudden additions to the contract or payment terms. All of the terms and conditions nitty gritty is resolved ahead of time.
Benefits of Dealership Financing:
- As a buyer, you can enjoy the one-stop-shop feeling with your car and financing all dealt with in a single location with all your paperwork handily kept together.
- Dealerships can often give you a lot of choice because they have relationships with multiple banks and finance companies.
- If you have a high credit score, you can enjoy zero-percent APR and other financial deals, something that no bank or credit union could offer you.
Auto-Financing: Direct Lending – A Closer Look
When you opt for the path of direct lending to purchase your vehicle, you are essentially purchasing two products — the car and the finance deal. You therefore need to regard the “shopping around” for the finance deal as an entirely separate process. That means you need to comparison shop, and negotiate with lenders where you can to try and get the best possible deal.
Read through and understand the different terms of the contracts. Some car finance deals may look better than others on the surface, but when you drill down further into the numbers, you discover that a seemingly more expensive deal is better in other ways.
First, understand the “amount financed” and the “finance charge.” This is where you often find the biggest difference between the numbers. The general rule of thumb is that the easier the terms of the loan appear month to month, the longer you’ll be paying and the more you’ll pay back overall. In other words, the final amount paid could be significantly more than the MSRP of the vehicle.
Second, get to grips with the APR. To help you with the first step, you’ll need to know about the annual percentage rate (APR), which is the interest that you pay on the car loan. The lower the APR, the less you’ll pay in interest over the terms of your loan. If your credit score is high, you can enjoy much lower interest rates. As you shop around, look closely at the APR of each one compared to the term length.
Third, know your credit score. Whether you use direct lending or dealer financing, your credit score is going to play a huge role in your auto financing. The table below shows how your FICO score impacts your APR on a 60-month loan for a new car:
|FICO Score||Average APR|
Finally, shop around for the best terms. One of the biggest advantages to using direct financing is that you can take yourself to the platforms of multiple lenders and see who can come up with the best deal overall. This is especially true if you have a strong credit rating. In the competitive world of auto financing, those with strong credit ratings present the lowest risk and are therefore highly desirable loan candidates. There are also dozens of competing institutions. Below is a selection of prominent lenders, along with their lowest and highest APR rates for auto loans:
|Lender||Lowest APR||Highest APR|
|Bank of America||2.59%||N/A|
Getting Pre-Approved for an Auto Loan
One more aspect to consider in the direct financing arena is on the order in which you get the financing. Some may shop for the car first, negotiate a price and then secure their financing based on that. They can use the knowledge of the exact price and the required down payment to better understand what the terms of their loan will be.
This is one way, but for many there is a more advantageous approach, and that is getting pre-approval. What this means is that a lender agrees in principle ahead of time to give you the amount you want. You can then take that knowledge to the dealership and use it to bypass any pressure they may otherwise apply in the sales process.
To get pre-approved, you’ll need your credit score, and have the following information ready to share with lenders:
- Employment info
- ID info (e.g. driver’s license number)
- Social security number
- Income information
- Details on any outstanding debt
- Tax filing documents
Remember that when you take your car loan into your own hands like this with direct financing, it’s crucial that you explore your options in advance and find terms that work for you. Direct lending is usually the simplest method of financing in many ways, though it’s not as convenient as getting your finance done via the dealership.
Dealership Financing: A Closer Look
In principle, some of the points on direct financing also apply to the world of dealership financing. One big area of difference, however, is in the scope of options. Direct lenders give you many options but all for the same thing, which is a car loan that you use to buy a new car from the dealership. You then pay that loan back at the agreed APR. Dealerships offer an additional path:
- Regular car loan – the dealership organizes a car loan much like the direct lenders do, although often with lower APRs because they ultimately hope to encourage customers to finance their cars with the dealership.
- Car leasing – the alternative deal that a bank or credit union can’t offer you, where you pay a monthly fee to the dealership to use the car for an agreed-upon length of time, after which you either buy the car outright, return it or trade it in.
Car Loans from the Dealership
Much of the information that we described for direct financing applies equally to the dealership, only with one major area of difference, and that’s the APR. It’s quite typical for dealerships to offer APRs at between 0-1% as a way of competing directly with the finance companies. Such rates aren’t available to all, and are largely dependent on your credit score.
We can demonstrate this using the Toyota Payment Estimator to see how different the dealership financing deals are depending on our current credit rating. Let’s say we were going to buy a 2021 Toyota Camry XLE 2.5L with a final price of $30,940. We put down a 20-percent deposit of $6,000. We purchase the Toyota over 60 months.
|Credit Score||Estimated APR (%)||Estimated Monthly Payment ($)|
|Excellent 720+||1.9 (guaranteed)||436|
|Very Good 689-670||3.9||532|
|Very Poor 609-580||13.84||683|
|Extremely Poor 579-520||16.84||729|
Many dealerships further tempt buyers with 0-percent loans, which some feel must be always too good to be true, but by and large are exactly what they say, which is a car loan for an agreed-upon time at zero-percent interest. Dealerships are often prepared to offer these as a way of simply taking business from banks and credit unions and keeping their customers entirely “in-house” when purchasing a car.
Unlike a bank or credit union, the car dealership has multiple channels through which it can make additional profit while offering a zero-percent loan:
- Agreeing higher sale prices with buyers using the leverage of a 0-percent loan
- Adding high charges, and even retroactive interest to any buyer who misses a monthly payment
- Sale of additional accessories or features
- Upselling the trim level by encouraging buyers to go for a higher price because they’ll pay no interest
A good rule for any buyer is that the better the terms of the loan sound, the more closely and carefully you have to read the exact terms and conditions. However, you shouldn’t dismiss zero-percent as just a gimmick or a meaningless gesture. They normally do really mean zero percent, but you’ll likely have to agree to other special conditions, and you’ll have to have the right credit score to qualify.
Beware: Negative Equity
One of the reasons why it’s important to negotiate hard when trying to get a car loan either from an independent lender or a dealership is the problem of negative equity. If you agree to a higher sale price, then there’s a risk that given the terms of your loan, the amount you still owe on the vehicle will exceed what the vehicle is actually worth. This is known as negative equity.
To avoid this trap, you can do three things:
- Budget carefully before you agree to any car loan terms. Work out how much you can afford from your monthly income to include the car payment, as well as insurance, registration, fuel and other costs each month. The best method is to work a figure you can afford monthly and then go 5-10 percent below that as your budget. This allows some wiggle room for any month where your budget tightens.
- Offer a larger downpayment. The more you can put down initially when buying the car, the less chance you have of falling into negative equity. A good rule of thumb is to put down 20 percent as a downpayment. After that plus 1 year of regular payments, you will most likely be at least in step with depreciation (20-25 percent in first year), or even slightly ahead depending on your exact model.
- Keep the loan period as short as possible. A shorter loan period means steeper monthly payments, but if you can afford it you should get as short a loan term as possible to first reduce interest payable in total, but also to ensure you can stay ahead of depreciation in the time you have the car. A period of 36-48 months is ideal.
The unique realm of the dealership is the ability to offer car leasing. This is just another form of financing where instead of paying for the car to steadily gain equity in the vehicle each month, you pay just the depreciation in return for the right to hold and use the car as you want.
Your monthly lease payment is calculated based on the sale value of the car, along with a lease charge and various other fees that are worked out into a single monthly payment. That payment is typically lower than that of a regular car loan because you are only paying for the depreciation of the vehicle and not for the entire amount.
Revisiting our 2021 Toyota Camry XLE 2.5L for a moment, let’s say we wanted to lease it this time. When we bought the car, we put down $6,000 as a deposit and had to pay $436 a month at the absolute lowest rate. When leasing, we can put down just a $2,000 deposit and enjoy different terms over a 36-month lease:
|Credit Score||Monthly Payment ($)||Annual Mileage (miles)||Due at Signing ($ incl. deposit)|
As you can see, credit score once again has a huge impact on your ability to lease at the best rates. When comparing to the purchasing rates further above, however, remember:
- The car loan period was 60 months, but the leasing period is only 36 months
- The car loan needed a downpayment of $6,000, but leasing just $3,000-4,000
- At the end of 36 months, you can trade in for the newest model
Car leasing also brings with it some unique expenses, such as Gap Insurance. This is a special insurance designed for those with car leases, and it covers the potential negative equity that could exist between your lease car’s current value and what you still owe on it. Your insurance policy will only cover the car to its current market value. If you totaled the car, and it was deemed to be worth $21,000, but you still owed $23,000 on it, then the gap insurance would cover that gap of $2,000.
Differences Between Car Leasing and Car Loans
It’s important that you understand that while both a lease and a car loan are forms of auto financing, they have very different implications, not to mention pros and cons. Here are some important things to compare and contrast about car leasing and car loans.
Compare: Changing Costs and Terms/Conditions
Both a car loan and car lease can come with flexible terms and conditions that may change as the agreed financing period progresses. Interest rates may change, additional fees and conditions can kick in at a certain point. This is why you should read through both the car loan or car lease terms and conditions very carefully.
Contrast: Exiting the Deal
One area that it can get somewhat difficult and complex is in how you might exit from a financial arrangement. With a car loan, it is relatively simple. All you need to do is to determine how much is left on the finance agreement. After that, you sell the car, hopefully for more than is left on the loan, repay the loan and keep any remaining cash for yourself; job done. If there is negative equity, then you’d have to cover it from your own pocket.
Exiting from a lease is a more difficult thing, however, since the terms and conditions are usually designed to deter lessees from exiting early. It can also damage your credit rating to renege on the terms of your lease. One thing you can do is to transfer your lease to another driver, perhaps a colleague or someone you know well. Dealerships are usually willing to allow a transfer just so long as the new lessee has the correct credit rating. When it comes to altering anything in your lease agreement, however, there are additional fees.
Compare: Incentives and Rebates
“Incentives and rebates” is an industry term used by OEMs and their franchised new car dealerships to refer to any and all policies and methods they use to boost sales and attract business from buyers. Above we mentioned one such policy, which is zero-percent car finance. Other examples include:
- Customer cashback
- Reduced APR for a fixed term
- Reduced monthly lease payments over a fixed term
- And more…
Incentives and rebates usually reduce sticker prices and monthly payments, but also frequently add terms and conditions. This is the same both for leasing and car loans.
Contrast: Concluding the Finance Period
Besides the contrast in what happens when you try to end the financing period early, there is a huge difference between car loans and leasing when you finish the finance period in full and as agreed.
When you have a car loan of, say, 48 months, and you reach the end of those 48 months, making the final payment, the car is now fully yours. You continue to use it and own it, no longer having to pay the monthly amount to a dealership or finance company. The asset is entirely yours to do with as you will.
When you reach the end of your car lease, however, there is additional finance to think about:
- Sign a new lease with a new car, perhaps the newest version of the same car you’ve previously leased
- Giving the car back, paying the end-of-lease fees and then moving on
- Buying the car with a single balloon payment to buy out the rest of the equity
In every instance, there are typically additional fees to be paid, even when you haven’t broken any terms and conditions. They will add charges like storage, transport and other costs. If you’ve damaged the car in any way, you’ll have to pay for that, and if you have exceeded the mileage limit, there will be additional fees there (see final point below).
One more point of contrast is in how you can use your vehicle. Part of your monthly leasing price is based on your estimated annual mileage. The higher your annual mileage, the more your monthly payment will inevitably be. The average American drives about 13,500 miles per year. The figures for the Toyota Camry lease we gave above were only for 12,000 miles. If when you return the car you are found to have exceeded this mileage, there are additional fees there, typically charged per mile in excess.
With a car loan, your annual mileage is not factored into your car loan cost. It is factored into your insurance cost, but that’s always the case. A car that you have purchased on finance allows you more freedom in terms of usage.
Conclusion: Consider Your Options Carefully
At the end of the day, every buyer has to think about their options carefully. If they want to keep things simple with a car loan, then they have to think about whether to use an independent lender or the dealership to get the best car deal. Some may prefer the no-hassle leasing approach, getting a car on demand, and then returning it at the end without having to deal with titles, resale and other troublesome details.
All auto financing comes with its own sets of terms and conditions. The smart buyer or lessee will shop around, read through the terms and conditions and think about all the related expenses: the initial expenses, the middle expenses and the final expenses. All could apply, depending on the nature of the financial deal that you strike.
Take time to consider your options, don’t let salespeople apply undue pressure, and remember that no matter how good a deal seems, there is sometimes an even better one to be had elsewhere. You could also consider working with us here at carbevy.com. Using our system, you can cut out the negotiation steps and simplify your path to getting the best price. You can then apply your pre-approved loans with ease, or explore other options.