Car Financing Basics
- Last Updated: Wednesday, 17 February 2021
According to statistics released by the Federal Reserve, the average car loan is nearly $30,000. Buying a car involves a considerable amount of money, and is oftentimes the second largest purchase decision made by households. The ability to understand and analyze the available financing options is critically important.
In this article, we're going to discuss the basics of car financing; which will include comparison shopping, how to buy a car on credit, financing terminology, as well as questions to ask lenders before making a decision. Finally, we're going to finish with several examples, demonstrating how to analyze the cost of a new car loan. We'll also provide links to online tools, which can be used to perform this comparison.
Shopping for New Car Loans
With slumping sales of new cars, automobile manufacturers continue to invent new ways to lure potential customers to their showroom floors. While low monthly payments, no money down bargains, and zero percent financing all sound like great deals, consumers should be able to make fair comparisons.
Before running out to buy a car, there are three very important factors an informed consumer should know:
- How much they can afford to spend on a car
- The available options when it comes to obtaining a loan
- Which financing option is the least cost
A new car loan will only add to the financial burden of households that aren't saving a lot of money each month. Before buying a car, it's worth the effort to create a household budget. Going through this process allows buyers to gain a better understanding of what "affordable" really means. A good rule of thumb is a car payment should be no more than 20% of a household's disposable income. That's the money left over after paying for living expenses, a mortgage, monthly utility bills, and credit card payments.
Prices of new cars can be found on websites such as CarsDirect.com, Edmunds.com or Kelley Blue Book. These websites will not only allow users to research prices, but also figure out how much their existing car is worth if it's going to be traded in as part of the purchase arrangement.
Comparing Car Loans
When it comes to car loans, it often pays to shop around. Typical choices include credit unions, local banks, and automobile dealerships. Finding a lender that provides a pre-qualification or pre-approval process allows the consumer to negotiate from a stronger position with car dealerships.
When comparison shopping for a loan, make sure there is a clear understanding of the assumptions used by the lender. Down payments, interest rates, term or length of the loan, are all important factors to consider when comparing offers. Don't be intimidated or afraid to ask a lender for information that's vital to understanding the terms and conditions of the loan.
Car Financing Terminology
There are several important terms to understand before buying a car and arranging for its financing. The following language will typically appear either as terms and conditions on a loan, or will be part of the loan origination process.
- Annual Percentage Rate: arguably the single most important factor to consider when comparing loans. The Truth in Lending law requires the annual percentage rate, or APR, to accurately reflect the total cost of credit. The way it's calculated allows consumers to make direct comparisons between offers. The APR is a standardized way of expressing interest rates, and the lower the value, the more attractive the loan.
- Amount Financed: this is the total value of the credit used by the consumer, including the principal amount of the loan, plus any charges which are not part of the finance charge, minus any charges which are part of the finance charge but will be paid before or at the time of the close on the loan.
- Finance Charge: the total cost of the loan including interest, fees, and credit checks. The finance charge is the total of all fees and interest charged on a loan.
- Total Payments: the sum of the amount financed plus the finance charge.
- Payment Schedule: the number, amount, and due dates for each of the payments scheduled to repay the car loan.
- Total Sales Price: the sum of the scheduled payments plus any down payment made on the automobile.
By discussing the above information with a lender, and asking questions about each factor, a consumer can be assured of getting the best possible deal.
Automobile Finance 101
Earlier we promised to demonstrate how an educated consumer can make a good choice when buying a car. We're going to do that by using some of the online car loan calculators we've made available on this website.
New Car Financing Example 1: Ford F150 Offer
At one time, Ford offered the following two deals on their Ford F150 truck line. Consumers had the choice of zero percent financing for up to 60 months, or a cash rebate of $3,545. So what is the best deal? We're going to use our simple auto loan calculator to help answer this question.
Statistically, the typical new car loan is for around 90% of the purchase price of the vehicle. Let's assume this consumer is buying a mid-range truck selling for $24,000, which means they're financing around $22,000.
Zero Percent Financing
Amount Financed: $22,000 Monthly Payments: $366.67 Interest Paid (0%): $0 Total Payments: $22,000
Amount Financed: $22,000 - $3,545 = $18,455 Monthly Payments: $356.79 Interest Paid (6.0%): $2,952.21 Total Payments: $21,407.21
This example demonstrates why it's so important to understand financing basics when buying a car. Even though zero percent financing sounds attractive, the cash rebate offers more savings in the long run. In this example, the buyer would save nearly $600 by taking the cash rebate offer.
New Car Financing Example 2: Cadillac STS Sedan
In this next example, Cadillac is running a similar deal on their STS model line. But this time the deal was a bit more complex, offering the consumer a choice of $1,550 in cash rebates with a 0% APR, 60 month loan or $2,450 in cash back with a 5.9% APR loan. The STS Sedan cost, at that time, was around $55,000. Once again, we're going to assume 90% financing, which works out to just about $50,000.
Zero Percent Financing, $1,550 Cash Back
Amount Financed: $50,000 - $1,550 = $48,450 Monthly Payments: $807.50 Interest Paid: $0 Total Payments: $48,450
5.9% Financing, $2,450 Cash Back
Amount Financed: $50,000 - $2,450 = $47,550 Monthly Payments: $917.07 Interest Paid: $7,473.92 Total Payments: $55,023.92
In this second example, the importance of understanding the concepts behind car loans and how to make intelligent choices is clear. The difference between these offers is over $6,570 during the five year life of the loan.
Understanding the calculations behind these two examples, along with the online tools offered, will help consumers to make a more informed decision. It's obviously possible to save thousands of dollars by making an informed choice when buying and financing a new car.
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