Vehicle Finance 101

Finding a car in budget shouldn’t be complicated, but there are a lot of unknowns when financing a vehicle. Read through the following frequently asked questions to better understand your financing options before signing on the dotted line.


Getting started

APR stands for annual percentage rate. Also commonly referred to as the interest rate, the APR tells you how much interest you will pay on your loan each year. A lower APR results in lower monthly payments.

New Car Financing

New cars will typically qualify for the best financing options. Lenders generally provide the lowest APRs and the longest finance terms for new cars. Some lenders will provide new car financing for used cars that are the current model year.

Manufacturer New Car Incentive Financing

Everyone has seen the special financing offers advertised on TV, in newspapers, and on the Internet. Low financing rates, such as 0%, 0.9%, or 1.9% APR, are typically incentivized rates offered by manufacturers (not dealers) to promote and sell their vehicles. Some manufacturers will offer these rates in place of rebates or "dealer cash," so you may receive less of a discount if you opt for these special financing rates. Be sure to check with your dealer before selecting these rates, as they may not always be the best option. Also keep in mind that the dealer does not decide if cash rebates and special financing can be combined. Lack of clarification with these promotions has been known to cause frustration for the consumer.

Certified Pre-Owned Financing

Similar to new car financing incentives, some manufacturers may offer special rates on Certified Pre-Owned vehicles. When choosing a pre-owned vehicle, be sure to clarify with your dealer whether the vehicle is certified and ask if there are any financing incentives on the particular model. Certified vehicles and financing are only offered at the respective franchise dealerships. For example, you can only buy a Certified Pre-Owned BMW from an authorized BMW Center. A Mercedes-Benz franchise dealer would not be able to sell a BMW under the BMW Certified Pre-Owned program.

Used Car Financing

When buying a used car, your financing options are vast. Some credit unions and lenders may have monthly used car APR specials, but they will not be vehicle-specific. These promotions are usually harder to come by and are not always advertised to the general public.

We have all seen low APRS of 0%, 0.9% and 1.9% advertised on TV, in the newspaper, on the radio, and on the Internet. These rates are typically incentives created by the manufacturers to sell new or Certified Pre-Owned vehicles. Often, these rates are only available for short-term financing and have minimum credit requirements. You should also keep in mind that some manufacturers may offer these rates in lieu of "dealer cash" or rebates. Depending on the amount of the cash incentive and your credit profile, the incentivized rate may not be your best option. Always ask to see the loan both ways.

A majority of automobile loans are known as simple interest loans. Similar to the interest on a mortgage loan, interest on an automobile loan is charged in addition to the original principal amount of the loan. You pay interest per day, also known as per diem, on the current principal of the loan. The higher your APR, the greater the portion of your payment is interest. With a simple interest loan, any payment in addition to your regularly scheduled payment will go directly towards the principal of the loan. There is no prepayment penalty on a simple interest loan. Your loan can be paid off at any time prior to the end date with no penalty.

Although there are differences between the three, those differences shouldn't affect your decision on which to use. Always do your homework, but it is typically safe to select the option with the lowest APR, assuming it is a simple interest finance contract.

The car dealership and what to know

Most car dealerships do not actually finance your vehicle. However, they arrange your financing through a network of banks, credit unions, and finance companies. Depending on the size of the dealership, they may have anywhere from 1 to 20+ professionals dedicated to the financing and registering of your vehicle.

Remember, the goal of the dealer is to sell you a car. The finance department is there to help execute the transaction and make the purchase possible. Even if you provide your own financing (also known as an outside lien) and do not finance through the dealership, the finance department is still responsible for recording the lien on the vehicle's title and completing the registration.

Car dealers sell and finance hundreds, sometimes thousands, of transactions each year. Do your homework but also listen to the options and suggestions that the dealer has to offer. In today's world of online reviews and social media, most dealers actually want to help.

You may be offered gap coverage when signing for your automobile loan. Gap coverage protects you in the event of a total loss if your loan balance is greater than the value of the vehicle. Some gap coverages even cover your insurance deductible in the event of a total loss. This coverage is optional and may not be necessary if you are in a positive equity position in your loan. Be sure to get all of the details from your dealer or finance company to see if gap coverage is beneficial for your particular situation.

Yes and no. Typically, lenders will offer a lower rate to dealers than what is available at their local branch. Dealers use a dedicated "indirect" or dealer lending department where loan applications are submitted electronically. However, some credit unions and membership banks may offer you a better rate than going through the dealer. Be sure to check all of your options.

Negotiation of an interest rate is a hot topic in politics. Some lenders still allow a dealership to negotiate your interest rate. As a consumer, it is hard to discern whether you can actually negotiate the interest rate presented. The best practice is to be well-informed of what rate you qualify for. Make sure that you are receiving a rate that is appropriate for your credit score and current purchasing position.

Some lenders will charge dealers a fee to acquire riskier loans. Dealers are not supposed to disclose if a fee is being charged nor are they allowed to ask you to pay the fee. However, if a bank fee is required, it could prevent you from securing financing on a specific vehicle. In other words, if the fee charged by the lender is too large for the dealer to pay out of their profit, the dealer may decide to pass on the deal.

Some dealers offer in-house financing, also referred to as "buy-here, pay-here" financing. These loans may not be simple interest finance contracts. We do not provide information or advice for this type of automobile financing.

Dealerships are compensated by the lender for arranging the financing. Depending on the lender, the dealer may be paid a flat fee or a percentage of the automobile loan. The compensation is typically determined by the total amount financed. Some lenders are also compensated based on the APR and profitability of the loan. This practice is known as dealer rate mark-up.

New car manufacturers offer their own financing options. Manufacturer financing is provided by a lender known as a captive lender. For example, a Ford dealer's captive bank may be Ford Motor Credit. Some manufacturer finance companies incentivize dealers to use their finance programs. Promotional low-rate financing on new cars that is nationally or regionally advertised by manufacturers is from a captive lender.

A straw purchase is when somebody purchases and finances a vehicle that is not intended for them. In this circumstance, a different individual who is not on the loan will be paying for and/or driving the vehicle. Most banks will not allow a "straw purchase" and will ensure that their dealers do not allow such transactions. Such purchases put both the individual on the contract and the lender at great risk.

Understanding your credit

Prime Lenders

Some lenders focus on credit profiles that are considered "Prime" or "A Paper." Depending on the specific lender, they do a majority of their automobile lending to qualified customers with credit scores above 650. Some lenders will have even higher minimum requirements. It is common to see lower annual percentage rates for large equity positions and shorter loan lengths. Some may not be partial to the loan term or equity position, within reason. Prime lenders typically have the lowest annual percentage rates available. Loan lengths may be available up to 84 months, depending on the lender. Typical APRs for prime lenders range between < 2% and 9%, depending on current market rates and financing terms.

Sub-Prime Lenders

There are specific lenders available for customers that are in the process of credit rebuilding or for those who have less than perfect credit. A typical credit score for a subprime lender is generally below 640. However, much more than credit score determines a subprime loan. The interest rate and term provided by these lenders is typically derived by credit history, previous automobile loans, and types of derogatory credit. The loan may be decisioned by an analyst or underwriter rather than a computer. Loan length may also be limited for customers with poor credit. Most subprime lenders will not lend past 72 months. Typical APRs will range between 10% and 29%, depending on state laws and specific lending programs.

Full-Spectrum Lenders

There are also lenders who offer financing for all credit profiles. Typically, larger national lenders will offer prime, near-prime, and subprime financing.

There are various websites and even credit card companies that give you quick access to see your credit score, but your automobile credit score may differ from what you see online. There are different credit bureaus for different types of purchases. The score you see online may be different from the score the dealership or bank uses. There are three credit reporting agencies that may be used to decide your auto loan: Equifax, TransUnion, and Experian. If you are a business, a Dun & Bradstreet report may be acquired. Always ask for the risk-based pricing notice for all three credit bureaus before signing for a loan. This notice will tell you your score and how it compares nationally.

Your credit score is only one part of your creditworthiness. In fact, the accounts in your credit report may have more influence on your automobile loan than the numerical credit score. For example, you may have a high credit score but have small previous loan amounts when compared to the new amount that you are trying to borrow. This can make the loan riskier in the eyes of the lender. If you have less than perfect credit, the credit analyst will look to see what types of accounts you have paid well compared to the accounts that were not paid as well. Generally speaking, medical collections are going to be more forgiving than a derogatory automobile loan.

Technically, the answer is yes. Running your credit can lower your credit score and will show up on your report as in inquiry, but don't be concerned—just be careful. An inquiry is usually needed for an institution to provide you with an accurate annual percentage rate. Multiple inquires can drag your score down. Be careful of a dealer submitting your credit to multiple banks. This is sometimes referred to as "shotgunning" someone's credit. To be safe, request that the dealer not submit your credit to a lender until you are ready to make a purchase and have agreed on figures.

If you are currently under bankruptcy, you will most likely need specific written permission from your trustee to finance a vehicle. Only certain lenders will lend to an individual under bankruptcy and will typically charge a much higher APR. If you are under bankruptcy, it is advised that you speak with your trustee prior to trying to make a purchase.

Individuals that have current or prior foreclosures or vehicle repossessions will have a more difficult time securing financing. In these circumstances, having a large sum of cash down or trade equity can be extremely beneficial to securing an automobile loan.

Basic lending parameters

Annual Percentage Rate

Generally speaking, the older the vehicle, the higher the APR will be. This may also be true for higher mileage vehicles. Vehicles less than 4 years old with less than 50,000 miles typically qualify for the lowest used-car APRs.

Available Loan Term

The age and mileage of the vehicle will also affect how long you can finance it for. The older the vehicle, the shorter the loan term may be. Due to term restrictions, it is possible to have a lower payment on a newer, more expensive vehicle than an older, less expensive vehicle. In other words, you can finance a newer vehicle for a longer period of time, effectively having a lower monthly payment.

Extended terms, typically 63-84 months, can result in a higher APR. Most lenders will have the lowest APRs for 24- to 60-month financing. Be sure to check with your dealer or lender to see what term makes the most financial sense for you.

What is equity?

Equity is determined by the difference between the value of your vehicle and the loan balance.

What is negative equity and how is it caused?

If your loan balance is greater than the value of your vehicle, you have negative equity. In-equity or negative equity is caused by your vehicle depreciating at a faster rate than the reduction of the loan principal. This is most common when purchasing a vehicle with little to no money down and/or using longer loan lengths. A higher annual percentage rate can also reduce the amount of money going towards the principal each month, effectively putting you at a greater risk of negative equity.

How will negative equity affect me? How can I prevent negative equity?

Negative equity can have several detrimental impacts to your car loan, from conception to trade-in. The most obvious problem with negative equity is the fact that you are borrowing more than your vehicle is worth. When acquiring a new loan with negative equity, the loan may have a higher rate, and you may be required to provide a larger down payment. Negative equity can also make it more difficult to trade in your vehicle due to the excessive balance owed. In addition, owing more than your vehicle is worth can put you at risk in the event of a total loss accident (see GAP protection).

If you have poor credit, limited credit, no credit, or if you are new to credit, a bank may require a cosigner. In some circumstances, you may qualify to purchase a vehicle on your own, but a cosigner may help you qualify for better financing options or even a more expensive car. Depending on the lender, it may be beneficial if the cosigner lives at the same residence as you.

You and your cosigner are equally responsible for the loan. Regardless of who is listed first on the contract, each party has an equal responsibility that the obligation to the lender is made. A cosigner can only be removed if the loan is refinanced. Be sure to completely understand the obligation before cosigning with someone.


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