Auto questions: how car financing works

Automobile loans will help you decide which financing option is best for you when you purchase a new car.

Unless you are Donald Trump, you probably cannot afford to walk onto a car lot and pay cash for that brand new, $100,000, Aegean Blue, German-made convertible you’ve had your eye on. Fortunately, there a number of financing options available to help you make your dream of car ownership come true.

BASICS ABOUT AUTOMOBILE LOANS

The first thing to understand about car financing is that an automobile loan is almost always a “secured” loan. That means that repayment of the loan is guaranteed or “secured” by the car. The car itself is collateral or “security” for the loan and the car does not belong to you free and clear until you have finished repaying the loan. Until then, the lender is a lien holder. In other words, while you may have possession of the car and be listed as the registered owner on the vehicle’s registration, the lender has a lien holder interest in the car. Accordingly, the lender is a legal owner of the car and is listed as such on the title until the loan has been completely repaid.

Because the car is collateral for repayment of the loan, there are typically a number of restrictions on what you can and cannot do with the car. For example, you generally cannot sell the car without the lender’s involvement to some degree. In most cases, if you do sell the car, you must sell it for enough to completely repay the loan and the payment must go directly to the lender. If you re-sell the car for less than the balance owed on the loan, you will have to either pay the difference yourself or obtain the lender’s permission for the new buyer to take over payments or “assume” the loan. Other restrictions may be included in your loan agreement. For example, you may or may not be permitted to take the car out of state. You may also be required by the terms of your loan to take good care of the car and to keep it in undamaged, operating condition.

Additionally, the lender will want to ensure that its collateral is protected. Accordingly, the lender will probably require you to carry comprehensive or full coverage insurance on the automobile until the loan has been repaid. In most cases, if you fail to keep the required insurance coverage in force, the lender is authorized to purchase insurance for the car and to charge this amount to you, the borrower.

Finally, because the loan is a secured loan, if the borrower fails to make payments on the loan and “defaults” on the loan, the lender is entitled to take possession of or “repossess” the car. The lender may then sell the car to cover its losses. If after selling the car there is still a balance owed on the loan, then the borrower remains responsible for repaying the balance, although he or she no longer has use or possession of the car. Most states have stringent consumer protection laws in place which govern the circumstances under which a lender may repossess a car. There are generally provisions allowing the consumer one or more opportunities to cure the default, reinstate the loan and regain possession of the car.

FINANCING BASICS

Since an automobile loan is a secured loan, the lender will first want to make sure that the security, in this case the car is worth enough to repay the loan in case the borrower does not make timely payments on the loan. The lender will probably want to visually inspect the car or at least see documentation regarding the car. The lender will want to know how many miles are on the car, what condition it is in and what options it has. For example, does the car have air conditioning, all-leather interior or a CD player? The lender will use this information to determine the value of the car.

Once the lender calculates the value of the car, the lender will agree to loan a certain percentage of that amount. The amount the lender will agree to loan will depend on a number of factors, including the borrower’s credit history, the borrower’s employment history and income, and the age and condition of the car.

There are a number of reasons the lender will only loan a percentage of the value of the car. First of all, it is fairly common knowledge that a brand new automobile loses a lot of its value the minute it is driven off the lot. So, if the lender loaned you the full value of the car, by the time you drove the car home and parked it in your driveway, you would owe the lender more than the car was worth. In this case, the collateral would not fully secure the loan.

Also, the lender is going to want you to put some money into the purchase of the car or make a “down payment” on the car. This is so the lender can see that you have an investment in the car as well. The reasoning is, if a borrower puts some of his or her own, hard-earned money into the purchase of the car, he or she is going to be more motivated to keep the car and, therefore, to make the loan payments. Accordingly, the borrower is required make up the difference between the sales price of the car and what the lender is willing to loan in the form of a down payment.

FINANCING OPTIONS

Unlike other types of loans, when you finance a car, the loan proceeds will not come directly to you. The lender will pay the money to the seller from whom you purchased the car. You will then owe the lender the money and make payments to the lender. There are a number of ways you can obtain financing for a car. The one that will work best for you will depend on several factors, most importantly your credit history and ability to repay the loan.

AUTOMOBILE MANUFACTURER’S FINANCE COMPANY:

If you purchase a brand new automobile car from a dealer, you will often be able to obtain financing directly from the company that manufactured the car. Most automobile manufacturers also have “in-house” finance companies. Everything will be taken care of for you right there on the lot by the salesperson who sells you the car. The salesperson will check your credit and your references, the contracts will be printed out and signed right then and there, and you can drive away with a new car in a relatively short amount of time. This is the simplest and fastest way to finance a car, but be warned that this can be more expensive than other options. Interest rates charged by the major automobile finance companies are usually higher than those available from more traditional lenders. Also, if you have a history of credit problems, it may be difficult to obtain financing from this source.

BANK OR CREDIT UNION:

If you have a customer relationship with a bank or credit union, then this may be the best option for you. Because you are an existing customer, the process is often a simple and quick one. Most importantly, your bank or credit union will generally offer you a much lower interest rate than another lender. Obtaining an automobile loan from your existing bank or credit union is generally the most desirable option, if you are able to do so.

FINANCE COMPANIES:

There are many companies in the business of financing purchases for consumers, whether it be the purchase of new living room furniture, a honeymoon trip to Jamaica, or in this case, a new car. Finance companies are generally not the first choice option for automobile loans. They usually charge significantly higher rates of interest than other lenders. They are also typically more aggressive about pursuing collection of the loan, including repossession of the car, if the borrower is slow in making payments.

SECOND CHANCE CAR DEALERS:

If you have had credit problems in the past or have declared bankruptcy, a “second chance” car dealer may be an option to consider. Second chance car dealerships are becoming more commonplace as difficult economic times take their toll on consumers. A second chance car dealer will work to obtain financing for a consumer who poses even the highest credit risk. Generally, second chance car dealers will require that you have proof of regular income at the very least. They may also require that you provide a large number of personal references. These dealerships are extremely familiar with the area’s lenders and use a variety of methods to obtain financing for high risk customers. For example, the dealer may put together five or more loan proposals, including yours, and offer them all to the lender as a package. The dealer may offer to place all five loans with the lender, perhaps four of which are “good” or low-risk loans, on the condition that the lender also fund your high-risk loan. A second chance car dealership may be a viable option if you have a poor credit history and are unable to obtain other financing. However, the loan terms will generally not be favorable. Expect high interest rates and perhaps pressure to make a higher or additional down payment that you may not be able to afford.

LINE OF CREDIT:

If you are purchasing a used automobile and have enough available credit on a bank line of credit or credit card, you may be able to purchase a car using your line of credit. Depending on the seller and the price of the car, you may be able to “charge” the car directly to your card. This might be an option if you are purchasing a very low-cost, used car from a used car lot. Or, you may be able to obtain a cash advance against your credit card or line of credit and then pay the seller with the proceeds of the advance. The advantage to using this method of financing is that you will probably not be required to use the car as collateral for the loan. You will be obligated to repay the advance of credit, but, depending on the underlying agreement with your credit card company, you will own the automobile free and clear of any liens. This may be desirable if you are purchasing an older car and, for example, do not want to be required to carry comprehensive insurance coverage on the car. The major disadvantage to financing your automobile purchase in this way is that interest rates on credit lines, credit cards or cash advances are often quite high.

PERSONAL LOAN:

Another option for financing an automobile is to borrow the money from a friend or family member. The advantage to this financing option is that you may be able to obtain a loan at a very low rate of interest, much lower than you would be able to obtain through a conventional lender. You would also have more flexibility to negotiate the terms of the loan, for example, whether the car’s title would be held as collateral for the loan or whether the loan would be unsecured by collateral. You may also be given more freedom with respect to the types of insurance coverage you purchase for the car. Use this option with care, however. A major disadvantage is that you risk damage to the relationship if at some point you become unable to make payments on the loan.

SOME FINAL TIPS:

Before you go shopping for a new car, be sure that you are familiar with current interest rates on automobile loans. Also, be familiar with your credit rating and know a range of interest rates for which you may qualify. Take advantage of the opportunity to “pre-qualify” for financing with a lender, especially a bank or credit union. That way, you will already know what you can afford to spend. You will have more leverage in negotiations for the sales price if you are not dependent on the dealership to provide you with financing options or information.

Finally, if you are forced to obtain financing from a less than desirable source and at a high rate of interest, remember that you are not stuck forever. Make your payments on the auto loan on time for six months to a year. In the meantime, open a credit union account and work to rehabilitate other poor marks on your credit. Then, once you have established a higher degree of creditworthiness, “refinance” the purchase of the automobile at a lower interest rate through your credit union or another lender. The new lender will pay off the existing, high-interest rate loan and you can then make considerably lower monthly payments to the new lender.