OK, you found the car of your dreams but you don't have the cash to pay for it outright. Well, who does? Most people finance their vehicles these days. It really helps if you shop for financing before you walk into the auto dealership.
An auto loan is very similar to a mortgage loan: you must qualify for the loan based on your credit and income. Most banks and auto dealerships carry loan products for people with less than perfect credit.
For fair credit, you should be able to get a loan for two to three percentage points above the "A" credit rates.
If you think you are being charged too much for a loan, you probably are. Shop around. There are a number of options when it comes to financing your auto loan:
Places to get conventional loan financing
Finance Companies - A finance company that is owned by an auto manufacturer, such as Ford Motor Credit or General Motors Acceptance Corporation, is called a "captive finance company." Captive finance companies account for approximately 20% of new car loans. Finance companies buy a loan wholesale, mark it up, and sell it retail. It may be easier to get credit through a finance company than through a bank, but it usually is at the cost of a higher interest rate.
Dealers - Be very wary of obtaining financing at an auto dealer. As in mortgage lending, the auto dealership typically has a large variety of loan products to offer you. Naturally, they will try to sign you up for a loan with the highest profit for the dealership. The larger the interest rate they charge you, the larger the commission given to the dealership. Some loan companies have a limit on how much they will allow an auto dealership to "gouge" you in extra interest percentage points, but some do not. It usually is best to arrange your own financing for the auto before you walk onto the car lot. As in the negotiations for your trade-in, treat financing as a completely separate transaction from the other two - talk only about one thing at a time.
Banks - Banks are the most common source for financing, accounting for about 40% of new car loans. You may be able to negotiate better terms, such as a lower interest rate, if you have a longstanding relationship with a bank. But you don't need to have an existing account at a bank to acquire a loan from them, so check with several banks in your area for the best interest rate. Some banks offer a pre-approved loan, which allows you some flexibility in shopping.
Credit Unions - You must be a member of a credit union to obtain a loan from them. They account for approximately 25% of new car loans. Credit unions offer the best loan rates - typically, one half to one percentage point lower interest than bank car loans. Further, credit unions typically charge simple interest, saving you additional money.
Online - The Internet allows you to compare rates nationwide, any time of day or night. There are several "e-loans" available exclusively online, and many sites also have built-in calculators to help you determine the cost of financing your vehicle.
Home Equity Loans - The positive difference between what you paid for your property and its current value is called the "equity." This equity can be used as collateral on a loan, which you could use to purchase a car. You can obtain a home equity loan at a bank or credit union. In effect, this is a second mortgage on your home and is, therefore, tax deductible. If you have an approved line of credit and don't have to pay any new origination fees, this is an especially good deal. But consider this type of loan carefully. You are using your home as collateral to secure your car loan and could potentially lose your house if you default on your auto payments!
Prepayment Penalties
Some loans have a prepayment penalty to insure the highest profitability possible. You need to be sure to ask your loan officer if the program he is offering you has a prepayment penalty attached to the loan.
Rule of 78s - an embedded, hidden prepayment penalty.
Sometimes a loan has a prepayment penalty built into it that doesn't appear to be one. This is called the "Rule of 78s." Suppose you want to pay off your loan early. You have your amortization schedule and calculate the payoff based on it. You call and tell your bank that you intend to pay off the loan two years early, and they throw out a payoff number much higher than your amortization schedule indicated. What gives?
When lenders use the Rule of 78s, they distribute the total finance charge over all payments but charge more interest early in the loan term and less later, compared with other methods. The Rule of 78s, also called "the sum of digits method," gets its name because the sum of digits 1 through 12, the months in a one-year loan, equals 78.
Here's how the Rule of 78s works for a 12-month loan: You pay 12/78 of the total finance charge the first month, 11/78 the second month, 10/78 the third month, and so on. The rule of 78s applies the same way for long-term loans. For example, a 24-month loan - where the sum of the digits for months 1 through 24 is 300 - would have a first month's interest of 24/300, second month's interest of 23/300, and so on. Interest on a 36-month loan would be broken into 666 parts.
Not sure if your loan uses the Rule of 78s? Look at your Truth in Lending disclosure. If you see a phrase like "you will not be entitled to any rebate of part of the finance charge if you prepay," ask the lender if it computes interest using the Rule of 78s.
Payment Shaver Loans
As lease payments are getting more and more expensive these days, some credit unions are offering a type of loan called a Payment Shaver Loan. This loan combines the low payments (up to 30%) found with a lease with the equity-building payments of a regular conventional loan. In addition, there are no up-front fees and no "disposal fee" often charged at the end of a lease.
At the end of a Payment Shaver Loan, the borrower has four options:
- Return the car to the credit union and the balance will be paid off.
- Sell the car and pay off the loan balance.
- Trade the car in and pay off the loan balance.
- Keep the car and pay off or refinance the balance.
Other nifty features of a Payment Shaver Loan include:
- You don't have to worry about a down payment or a security deposit.
- It offers a mileage allowance of as much as 18,000 miles a year, with a penalty of eight cents for each additional mile.
- Other than excess mileage, you have little to worry about at the end of a Payment Shaver Loan. The car will be examined for insurable physical damage, including damage to the windows, grille, or headlights, and missing or stolen items. But that's it. You won't be charged for a nick in a door or a small stain on a seat.
Other things to remember
The single most important thing you can do to ensure you get the best financing deal for your new car is to ask questions. Lots of questions.
What is the ...
- precise (down to the penny) price I'm paying for the vehicle?
- total amount (be exact) being financed?
- amount I'm paying for the credit (finance charge)?
- annual percentage rate (APR) I'm paying?
- exact amount of each payment?
- total number of payments?
How about auto leases? Read our article on auto leasing.
