Smart Car Financing for Beginners

Most automotive consumers don't have readily available cash for car purchases. They need to finance. However, auto financing is not a subject most people learn in school and many go into it blind when they make their first car purchase or lease.

Car loans can come from a variety of sources: the buyer's family or friends, a local bank or credit union, a national bank, an online loan company or broker, or through a dealer. Car dealers typically do not finance their own loans. They arrange financing on behalf of their customers through a car manufacturer's finance company (GMAC, Ford Motor Credit Corp, etc.) or a large national bank. Some low-end used-car dealers, such as buy-here-pay-here dealers, source their own loans. It's important for first-time car buyers to understand that it is not necessary, and often not wise, to get dealer-arranged financing.

First time car buyers may have difficulty getting a loan if they do not have an established credit history, have little or no job history, have limited income, or have excessive debt. The solution for most people in this situation is to get a family member to co-sign a loan with them. A co-signer is not a co-buyer, but simply a responsible party to which the loan company can come if the original borrower fails to make payments. Having a co-signer is a good solution because it not only gets the loan, but it allows the borrower to build a good credit history so that a co-signer will not be necessary the next time he needs a loan.

Car loans have four important components:
  • loan amount
  • interest rate
  • term (months)
  • monthly payment
Loan amount - Loan companies and banks determine how much money they are willing to advance to a borrower, based on the value of the car being purchased and the ability of the borrower to repay the loan - based on income and debt. It is possible that the approved loan amount may not be sufficient to pay the entire cost of the car. In this case the buyer will have to have cash to make up the difference as a down payment.

Interest rate - Finance companies make money by charging interest on loans. Interest rates can vary based on the credit score of the borrower, the finance company's policies and rate structure, whether the loan is for a new or used vehicle, and the term (months) of the loan. Individuals with lower credit scores pay a higher interest rate. Some banks and finance companies charge higher or lower rates than others. New-car rates are generally lower than used-car rates. Longer loans typically have higher rates than shorter loans. Dealers' finance companies do not necessarily have higher interest rates than banks or credit unions. In fact, it is common for dealers to offer limited-time 0% or low-interest promotional rates that can't be matched by local banks or credit unions.

Term - First-time car buyers often opt for very long loan terms, up to 84 months (7 years), to get the lowest possible monthly payment. This is generally not a good idea for the following reasons. Loan terms of 60 months or more usually have higher interest rates, compounding the total finance charges paid during the loan. This also contributes to the loan being "upside down" during almost the entire term, which complicates matters in the future when the buyer wants to sell or trade before the loan is paid off. It also makes for a large financial risk if the vehicle is destroyed in an accident, or stolen, because insurance only pays the vehicle's market value, not the remaining loan amount.

Monthly payment - Car loan payments are calculated using a complex financial formula not easily done by hand. Use a business calculator or online loan calculator. First-time car buyers often underestimate payment amount due to a lack of understanding of the calculation. First-timers should avoid "payment buying" - negotiating monthly payment with dealers - without also understanding the loan amount and interest rate that the payment is based on.