Financing a new or used car can feel stressful — especially in today’s climate. When you factor in your credit score, today’s interest rates, and the cost of owning a car, will it be too much?
In this blog, we’ll walk you through the basics of auto financing to help you feel more confident and empowered when you head to the dealership. We'll also discuss the types of loans, interest rates, and the application process.
What is Auto Financing?
Auto financing is the process of borrowing money from a lender to purchase a vehicle. Auto financing is a great way to purchase a vehicle if you don't have the cash to pay for it outright. However, it's important to understand the basics of auto financing before you sign on the dotted line.
With a deeper understanding of auto financing, you can make an informed decision about whether an auto loan is right for you.
“I hear from listeners all the time who are looking forward to getting a new vehicle but dread going through the financing process,” says CarPro Radio Show Host, Jerry Reynolds. “Honestly, there is nothing to be concerned about if you understand what will happen once you get into the finance office.”
Types of Auto Loans
There are two main types of auto loans: secured and unsecured. A secured loan requires collateral, which is usually the vehicle itself. In other words, if you don't make your payments, the lender can repossess your vehicle to recoup their losses. Secured loans typically have lower interest rates than unsecured loans because the lender has less risk.
On the other hand, an unsecured loan doesn't require collateral. Instead, the lender will look at your credit score, income, and other factors to determine whether you're a good candidate for the loan. Unsecured loans typically have higher interest rates because the lender has more risk.
Interest rates are the cost of borrowing money. When you take out an auto loan, you'll be charged interest on the amount you borrow. The interest rate will depend on your credit score, income, the amount of the loan, and other factors. Generally, borrowers with better credit scores will qualify for lower interest rates.
When shopping for an auto loan, it's important to compare interest rates from different lenders to find the best deal. Even a small difference in interest rates can make a big difference in the total cost of the loan.
To apply for an auto loan, you must provide information about yourself and your finances. This will include your name, address, employment history, and income. You'll also need to provide information about the vehicle you want to purchase, including the make, model, and year. In most cases, the dealership will take care of this part.
Once you've provided this information, the lender will review your application and make a decision about whether to approve you for a loan. If you're approved, the lender will provide the loan terms, including the interest rate, repayment schedule, and any fees.
How Do Credit Scores Impact Automotive Financing?
Credit scores are an important factor that can have a significant impact on auto financing. Your credit score is a numerical representation of your credit behavior, based on factors such as your credit history, payment history, and outstanding debts.
When you apply for an auto loan, the lender will use your credit score to assess your risk as a borrower. If you have a high credit score, you're more likely to be approved for a loan and to receive more favorable loan terms, such as lower interest rates and fees. A high credit score indicates to lenders that you're a responsible borrower who is likely to repay your debts on time.
On the other hand, a low credit score may mean you’ll have a harder time getting approved or you may be offered less favorable loan terms. A low credit score suggests to lenders that you may be a higher-risk borrower who is more likely to default on your loan.
In addition to impacting your ability to get approved for an auto loan and the loan terms you're offered, your credit score can also impact the overall cost of your car purchase. Higher interest rates result in a higher monthly payment, and you'll pay more in total interest charges over the life of the loan.
What Are the Advantages of Financing a Car vs Paying Cash?
"I often get this question," says CarPro Jerry Reynolds: "Will I get a better price by paying cash for my next car?" While there was a time when the answer was yes, you can often get a better price by financing the car with the dealership from which you are purchasing."
To give you an idea of what the finance market looks like today, we turn to data shared by Edmunds. With new and used vehicle pricing up, it's no surprise that down payments are also up. Edmunds recently reported that average down payments hit record highs for new and used vehicles in the fourth quarter of 2022:
- $6,780 is the new vehicle average down payment
- $3,921 is the used vehicle average down payment
In some cases, you may be able to negotiate a better price for a car by paying cash because you’re eliminating the dealership’s need to make money on financing, and they may be willing to offer you a discount for paying in full.
However, it's important to keep in mind that the actual amount of the discount will depend on a variety of factors, including the type of car, the dealership's policies, and the market demand for the vehicle. Additionally, some dealerships may prefer to finance your purchase because they can earn a commission on the loan, which means they may not be as willing to negotiate on price if you're paying cash.
To get the best possible price for a car, it's a good idea to research ahead of time and compare prices from multiple dealerships. You can also negotiate the price of the car separately from the financing, regardless of whether you plan to pay cash or finance the purchase. By being prepared, informed, and willing to negotiate, you may be able to secure a better deal on your car, regardless of how you plan to pay for it.
Pros and cons to financing a car vs. paying cash
Pros of Financing a Car:
- Lower upfront costs: Financing a car allows you to spread out the cost of the vehicle over time, which can make it easier to afford a more expensive car than you could buy with cash.
- Builds credit: Making timely payments on a car loan can help build your credit history and improve your credit score.
- Access to newer cars: Financing allows you to access the latest models, which may have newer safety features, better fuel efficiency, and other desirable options.
Cons of Financing a Car:
- Interest payments: Financing a car means you'll have to pay interest on the loan, which can significantly increase the total cost of the vehicle over time.
- Long-term commitment: Car loans typically last for several years, which means you'll have a long-term financial commitment that can limit your financial flexibility.
- Depreciation: Cars depreciate in value over time, meaning you may end up owing more on your loan than the car is worth if you try to sell it before the loan is paid off.
Pros of Paying Cash for a Car:
- No debt: Paying cash for a car means you'll own it outright and won't have to worry about making monthly payments or accumulating debt.
- Lower total cost: Paying cash means you won't have to pay interest on a loan, which can save you thousands of dollars over the life of the vehicle.
- More financial flexibility: If you pay cash for a car, you'll have more financial flexibility and can use the money you save on interest to invest in other areas or to build up your savings.
Cons of Paying Cash for a Car:
- Limited options: Paying cash may limit your options regarding the type of car you can afford. You may need to settle for an older or less expensive vehicle that may not meet your needs.
- Reduced liquidity: Paying cash for a car means tying up a significant amount of money in a depreciating asset, which may reduce your liquidity and limit your ability to access cash in an emergency.
- No credit-building opportunities: Paying cash won't help you build your credit history or improve your credit score.
“Thinking back to my years in the retail auto industry, I came across a lot of people who wanted to throw around the fact that they were paying cash. They were determined that they should get some sort of special deal because of that.
The truth was, as a car dealer, I didn't really care how we got our money. Whether cash, credit union, bank or one of our finance sources, we got our money quickly, often the same day, so waving a blank check in front of me did not carry any weight when it came to pricing my vehicles.”
Ultimately, the decision of whether to finance a car or pay cash will depend on your personal financial situation, goals, and priorities. If you have the cash to pay for a car and want to avoid debt and interest payments, paying cash may be the right choice. On the other hand, if you need to spread out the cost of a vehicle over time or want to build your credit history, financing is the better option.
What to Expect When Financing a Vehicle
Here’s what to expect as you enter into a car loan with a dealership.
- Preparing the paperwork: The finance department is responsible for preparing all the necessary paperwork for the sale of a vehicle. This includes the sales contract, the financing documents, and any additional agreements related to the sale.
- Negotiating the terms: The finance department works closely with the customer to negotiate the terms of the sale. This includes the purchase price of the vehicle, the down payment, the interest rate, and the length of the financing term.
- Running credit checks: Before financing a vehicle, the finance department will run a credit check on the customer. This helps to assess the risk of lending money to the customer and to determine the interest rate that will be charged.
- Approving financing: Once the credit check has been completed, the finance department will either approve or reject the customer's application for financing. If approved, the customer will be offered a financing package that includes the interest rate, the length of the loan, and the monthly payment amount.
- Selling extended warranties: The finance department will also offer the customer extended warranties and other add-ons that can be purchased with the vehicle. This is an additional source of revenue for the dealership.
- Finalizing the sale: Once the terms of the sale have been agreed upon, the customer will sign the necessary paperwork and pay the down payment. The finance department will then process the financing and finalize the sale.
- Managing collections: The finance department manages the collections process if the customer falls behind on their payments. This may involve contacting the customer to arrange payment, or in some cases, repossessing the vehicle.
"Beware: Like every profession, there are good dealers and bad dealers," says Jerry Reynolds. "Many people are taken advantage of in the finance department of dealerships. Over the years, we have seen it all — high-pressure tactics to purchase extended warranties, credit life, and disability insurance, GAP insurance, etc."
Here are some things to watch for:
The finance experience does not have to be a trying experience. This seems basic and simple, but it is critical that you understand you are signing a contract — a legal and binding document that obligates you to make monthly payments on a timely basis. Read what you sign. Don’t rush through this part. Look at the numbers and terms, and if you see something you don’t like, advocate for yourself. Ask questions.
It is no secret that a dealer makes money on almost every product it sells. Remember all additional products are optional — nothing has to be purchased in the way of optional policies or products. There are worthwhile products — extended warranties and GAP insurance just to name a couple — but they are totally up to you. Nobody will force you to buy anything.
Dealers first and foremost provide financing as a convenience to their customers, to help complete the sale under one roof. In many cases, the auto manufacturer offers extra rebates if you finance with its captive finance arm, like Ford Credit, Hyundai Financial, and others.
Doing your homework is always a good idea — research rates before you go to a dealership. Talk to your banker or credit union to know what interest rate you can get, — don't leave it to chance. Know how many miles you drive annually to know which extended service policy to buy.
Get online and calculate what your payment should be. Buying a car and committing to five or six years of payments should rank right up there with buying a home, and be taken as seriously, especially when it comes to reading and signing paperwork. Once you know what interest rate you can get on your own, give your dealer a chance to get you a better interest rate — they often can. If the dealer can save you a quarter to half a percent on interest, let them have the business and pocket the savings.
One good rule of thumb is to look at every line on the finance contract with a dollar amount next to it. You will see normal charges for tax, title, and license, but if there are any added items, they must be broken out on the contract itself, so they are easy to spot.
Today, many captive finance sources (Ford Credit, GM Financial, Toyota Financial Services, etc.) offer extra rebates for financing with them. Sometimes, there are amounts as large as $1,500. Cash buyers are often put off by this and get angry with their car dealers, but the truth is, the dealer cannot control this.
The finance companies offering the rebates are enticing you to finance with them, of course, to make a return through interest rates. They hope you will decide to keep the loan so they can make money. In these cases, the savvy cash buyer will proceed with financing the car, get the benefit of the financing rebate, and simply pay the car off in full before the first payment is due. You get the full benefit of the extra rebate and get to write a smaller check. The finance companies know a lot of people will do this and they are fine with it. However, others will not go through the process.
Should You Get Pre-Approved Before Car Shopping?
This is difficult to do, actually. You can find out from your bank or credit union the best possible interest rate, but until the loan officer can see the actual numbers on the car you picked out, most lenders will not do that. The lender wants to know how much you want to borrow versus the collateral, the car. In other words, they don't want to loan $50,000 on a vehicle with a $40,000 MSRP.
Can I Pay Off My Vehicle Loan Early?
Yes, in most cases, you can pay off your vehicle loan early. However, it's important to check with your lender to ensure there are no prepayment penalties or fees for paying off your loan early.
Paying off your vehicle loan early can have several benefits. First, it can save you money on interest charges. When you pay off your loan early, you'll have less time to accrue interest charges, which means you'll pay less in total interest over the life of the loan.
Paying off your loan early can also help you build equity in your vehicle. When you owe less on your car than it's worth, you have equity in the vehicle, which can be used to trade in your car for a new one or sell it outright.
However, before you pay off your vehicle loan early, it's important to make sure that you're not sacrificing other financial goals or priorities. For example, if you have high-interest credit card debt, it may be more financially beneficial to pay off that debt first, rather than paying off your car loan early.
Ultimately, the decision to pay off your vehicle loan early will depend on your individual financial situation, goals, and priorities. If you have the financial resources to pay off your car loan early and there are no prepayment penalties or fees, it may be a good option to save money on interest charges and build equity in your vehicle. However, it's important to consider all of your financial obligations and priorities before making a decision.
Financing Your Vehicle
Finding the right car for you starts with knowing what features you need, how often/far you plan to drive, and how much you can afford. Paying in cash or financing your car will also depend on your budget and your credit score.
Start by shopping our online inventory of cars to see what stands out. Once you find something you like, research interest rates before you head to the dealer.