A Comprehensive Guide to Car Finance

A Comprehensive Guide to Car Finance

Here’s an interesting thought to start your day: how many people that you see driving their cars around you during your morning commute are actually the outright owners of their vehicles? Are you even the outright owner of your vehicle? The numbers may astound you.

The fact is that there are millions of drivers out there who are still making payments on their cars — millions upon millions. A huge number of cars are still technically owned (or at least partially owned) by the many financial institutions that put up the cash to create the car loans that we use to get those cars off the lots and into our driveways.

Here are few jaw-dropping statistics that should open your eyes a bit more to the world of automotive financing. These will likely surprise and/or possibly shock you.

  • The peak year for car loans was 2016 when a total of 27.54 million loans were issued.
  • Auto loans only account for 9.28 percent of America’s overall credit, but 85 percent of newly-purchased non-commercial vehicles are bought on finance.
  • According to USAToday, the average monthly repayment value is $550 for new car loans, $393 for used-car loans, and $452 for monthly leasing payments.
  • By January 2020, auto loan debt had accumulated to $1.2 trillion in the USA
  • Lending Tree reports that around $56 billion is being borrowed every single month by Americans looking to buy cars.

Despite these facts, there are perhaps even more people who apparently don’t know a great deal about auto financing. It’s quite an involved world that’s worthy of our attention and our scrutiny. In today’s blog, we will hopefully create a much clearer picture in people’s minds about what the world of auto financing is, what kind of products exist, how much they really cost us and whether or not certain types of financing are really a good idea. Strap yourselves in because this one will give you serious food for thought.

Auto Financing: Dealership Financing Vs. Direct Lending

This is a great place to start our look into the world of auto financing. Broadly speaking, these two types of financing cover all the ways in which people now purchase their cars with finance agreements.

What is Dealership Financing? What Are Its Benefits?

When you opt for dealership financing, that means you’re going down the “one-stop shop” route. Instead of searching for outside lenders to give you the money you need to buy the car you want, you instead get your financing applied for and approved right at the dealership when you’re buying the car. There are certainly a number of advantages to doing your car financing in this way, which we’ll detail below.

Although dealership financing appears to be done all in-house, it’s not always the car company itself lending the money, although some OEMs like Toyota do have a financial wing for this type of thing. Most of them still have deals with outside lenders and get the money that way.

So, what are the benefits of pursuing the dealership financing route?

First, the convenience factor is very hard to deny. By getting your financing at the dealership, you eliminate the need to do any shopping around for yourself, and you can open and close your car-buying experience all within one single location. The millennial generation (Gen-Y) and also the emerging Gen-Z have already revealed to modern researchers their hatred of face-to-face negotiation. They therefore appreciate convenience more than any other previous generation, which is why dealership financing is the most attractive option to them.

Second, dealerships can offer lower interest rates, sometimes even zero-percent if your credit score is high enough. Companies like Toyota, for example, offer rates under 2 percent for those with high credit scores. Holiday periods like Black Friday have been known to bring crazy-sounding loan periods like zero-percent APR for 5 or 6 years on brand-new models or models that are just about to slip into the previous model year.

Dealerships can do this because interest on the finance isn’t their only source of income. If they can make some money from the interest, then that’s useful to them, but they can offer 1 percent or even zero percent and still make money by selling extras on the car like accessories, features packages and more. They can also add service fees. Lending institutions don’t do this, since interest is their primary source of income.

A further benefit is the choices. Those dealerships who are working with outside lenders to provide the loan capital often have relationships with many big lenders and thus can often do a better job than you in shopping around to secure the best deal. Lenders will also offer great deals to dealerships to incentivize them to sign more loans with more customers.

One additional choice that dealership financing is able to offer you as a customer is car leasing. We’ll deal more with that when we get “into the weeds” further below. Essentially car leasing is another form of dealership-based financing where you take the car for a fixed period and make payments on it but don’t gain full equity until either making a final balloon payment, or returning it and trading it in for another lease car.

What is Direct Lending? What Are Its Benefits?

Next we move on to the other major avenue of lending, and that’s seeking direct financing from a bank, credit union or other lending organization. Just about all major financial institutions offer some form of auto loans. They’re very popular financial products and are typically safe since they have smaller repayment plans than property mortgages.

What are the benefits of going down this road?

First, it’s easy to comparison shop when you get the information yourself. Dealerships may tell you they compare deals from different lenders they are connected with, but there’s no way for you to properly verify that, or at least not easily. When you explore direct financing yourself, you’re sure to understand the terms offered by every lender and can make a meaningful comparison.

Second, getting an auto loan in advance means you know your maximum budget. Direct lending is a great way to avoid the awkwardness and disappointment of picking out your car and extra features only then to be turned down for the financing at the dealership. If you get a loan from a credit union for example totaling $25,000, then you already know how much you can spend at the dealership. Everything under that amount reduces your overall monthly costs, and there’s no need to even go over it because you know how much you’ll have.

Third, just as you know the amount of money you’ll be getting, you’ll also know all the terms in advance before you go car shopping. Based on the terms that you already know and understand, you can make a better-informed choice of vehicle at a dealership because you will know which vehicle brands are more reliable and thus cut down on maintenance and other costs, which means you keep unexpected costs of running down. Sudden additional costs can put a lot of strain on you when the loan repayments are hard enough.

Finally, direct lending allows you to buy from outside a dealership. If you get a loan from outside, you can spend it on any car that’s for sale, including those being privately sold. If you go for dealership financing, on the other hand, you have to settle only for what they have there if you want that particular financial deal.

Into the Weeds: Looking Closely at Dealership Financing

Next we’ll take a more detailed look at some of the key aspects of dealership financing. We’ll cover several areas, including:

  • Car Loans Vs. Car Leasing
  • New Vs. Used Cars
  • Zero-Percent APR Loans
  • “Going Underwater” with car finance
  • Other problems with dealership financing


Car Loans Vs. Car Leasing

The two forms of financing on offer at the dealership are the regular car loan and the increasingly common car lease. These two have quite different formats, but are both still just another form of lending.

Car loans are the ones that most people are already familiar with. You agree to the terms of a car loan in advance, and then borrow that sum of money over a fixed period, most commonly of 4 years but sometimes fewer and sometimes more depending on the car’s cost and the buyer’s budget. A 4-year (48-month) loan is paid back with an initial deposit of 10-20 percent of the sale price, and then followed by 48 equal monthly payments.

Car leasing is a newer model but also very popular nowadays for its flexibility. In a car leasing model, the customer signs an agreement usually for three years. They pay an initial deposit followed by regular monthly payments for the full three-year period. It sounds the same as a loan so far, but the big difference is what happens at the end of 36 months.

When the lease is up, lessees have a choice. They can usually either pay a final balloon payment and then own the car outright, return the car to the dealership and end the leasing agreement completely, or trade it in for a similar model but newer for the same or very similar terms that they leased the last one.

Quick Comparison – Loan Vs. Lease

Car loans are clearly a great choice for those who intend to own a vehicle for a long period or who don’t want to worry about damaging or overusing the car. Lease agreements typically come with annual mileage restrictions and so aren’t useful for those who need more open-ended terms and have unpredictable driving lives.

Leases are, however, a great choice for those who move to a new location for a fixed period, or work within a company for a fixed time and need a car for that period alone. It removes the hassle of having to deal with the car when you’re done with it because you can just return it to the dealership. The monthly payments are also typically lower than those of a car loan.

Loans – Typical Terms

An excellent credit score of 720 or more can earn you the right to a dealership loan with an annual interest rate of just 1.9 percent — that’s if they don’t have any zero-percent APR loans on offer —and with a 20 percent deposit you could expect your monthly payment on a car costing $30,000 or so to be $435/month over 60 months (5 years).

A poor credit score of 625 could raise your interest as high as 11.84 percent, making the same terms for the $30,000 car mentioned above cost you a monthly payment of $654. That’s obviously a big difference. The lower option plus insurance costs monthly could work out to be the same as just the monthly repayment when your credit is poor.

Leases – Typical Terms

We looked into what it would cost to lease a typical popular sedan like the Toyota Camry. For the loan, we used a $6,000 deposit, but for the lease, we’ll just use $2,000. If our credit score is excellent at 720, then we can expect to pay as little as $362 per month. That price gives us 12,000 miles a year mileage as well, which is 2,000 miles above the average offering of 10,000 a year.

If your credit is poor at just 625, then your lease payment goes up to $670, and you may have to pay an additional $1800 or so when signing the lease and taking the car away. It should be noted, however, that the leasing period is only 36 months, whereas our car loan was borrowed over 60 months. That makes quite a difference and shows leasing overall to be cheaper.

Car Leases – Gap Insurance

One more expense to factor in when looking at car leases, however, is gap insurance, which covers any gap that may emerge between the amount you still owe the dealership on the lease, and the amount of money the car is worth as covered by the insurance. Let’s say the car’s depreciated value was $22,000, but you still owed the dealership $24,000 on the lease, then the gap insurance would cover that $2,000 gap in the event that you had an accident and the insurance didn’t cover all the money you owed to the dealership.

New Vs. Used Cars

Another aspect to consider in auto financing is whether you’re getting the terms on a new car or on a used car. Interestingly, it’s easier to get auto financing with better terms on a new car than it is on a used car, especially when you are getting financing from the dealership.

Direct lenders are actually unlikely to lend at all to buyers wanting to buy a used car, even though they are less expensive overall. Having said that, getting credit on a used car is a bit easier at the dealership if you are a buyer of a poor credit score currently. The lower price means a lot less risk for the dealership because you’re more likely to be able to afford the repayments.

If you have strong credit and are going to look at car loans, it’s worth getting the loan on a new car just because you can get good terms, keep up with them easily and thus build your credit score even further. If you have bad credit, on the other hand, then you can work to rebuild your credit score by taking on a low-pressure used car on finance. In this way, you’re more likely to get loan approval.

Zero-Percent APR Loans

Those with superlative credit scores may qualify for zero-percent loans. As we mentioned further above, these are loans offered to top-tier customers and although they do seem too good to be true — how could zero-percent APR really be a thing? — they are often legitimate and mean what they say when they’re from car dealerships.

However, there are nearly always important caveats to be aware of with this type of loan. First of all, the terms and conditions can be very strict. While they seem generous to offer you 0% in the beginning, if you miss even one single payment, they may reset you to a different APR, and then apply that retroactively to the months you’ve already paid. It can be a bit of a trap in that way.

These are loans for those who can guarantee to make their monthly payments and be able to set aside good sums of money to keep the payments up even if a worst-case scenario like job loss happens. On the other hand, no interest means that you could probably reduce the number of months and pay the loan back faster. The difference from no interest could make paying over 36 months about the same rate or only slightly more per month than paying over 48 months. Obviously, that’s great for you to repay the loan sooner and own the car outright.

“Going Underwater”

Further above we mentioned the problem of negative equity that can happen in car leases that are covered by gap insurance. The same can happen when taking a dealership loan. Depending on how well you negotiate the terms of the deal and how fast the car depreciates, you might end up with a finance deal that ends up “underwater.” This means simply that the deal has entered negative equity.

For example, if you put down a very small deposit on a car, and then are only making modest monthly payments over 60 or 72 months, then there is a chance that the depreciation of your vehicle will overtake your repayments. To avoid this situation, the best thing to do is always put down at least 20 percent as a deposit, since most cars depreciate somewhere between 10 and 20 percent after the first year, but then start to slow down. If you’ve paid 20 percent plus 12 months of payments, you’ll always be out in front.

Other Problems with Dealership Financing

  • It’s hard to know for sure if the dealership has got you the best-possible terms. You have reasons to logically assume that they will get them in order to secure your business, but unless you also do the legwork and shop around, you can never be 100-percent sure.
  • Car leasing is seen by some as a foolhardy way of engaging in car financing because it means you are spending money every month but never gaining any real equity in the vehicle. Only if you are certain you will make the final balloon payment do your monthly payments really equate to equity.
  • Car leasing also can have a lot of hidden charges and it’s very difficult to exit a car lease without incurring serious penalties. Loans are typically easier to exit from, as long as you can sell the car for enough money to cover the remaining balance.

Into the Weeds: Looking Closely at Direct Lending

First of all, you should know that some of the purely financial matters that are discussed for dealership financing also apply to the world of direct lending. The first big difference is that direct lenders won’t offer you a leasing deal, since they mostly just deal in capital to help you buy a car outright.

Below are some key concepts to get to grips with when it comes to direct lenders, though.

Credit Scores

Just the same way that it does with dealership financing, your overall credit score will have a huge impact on your APR. Below is a simple table that reveals data from valuepenguin.com to show the difference in APR ratings for people of differing FICO scores.

FICO ScoreAverage APR

As you might expect, there is a large disparity between those with good and bad credit when it comes to getting loans. If your credit score is low, therefore, you should expect to only be able to borrow less, perhaps only enough to cover a used car.

Shopping Around

One benefit of getting your own finance outside of the dealership is that you can shop around and find out who will make you a better offer. Take a look below at some examples that seem even to buck the FICO score average trends that we listed above:

Direct LenderLow-End APRHigh-End APR
PNC Bank2.79%14.99%

It’s worth finding out who will give you these different rates. These numbers were put together from data on valuepenguin.com and bankrate.com. Lenders have to compete with each other which means there may be lenders who fight for your business, especially if your credit score is good and you are lower risk.

Buying Within Your Means

An advantage of direct lending is that it makes it easier to buy within your means. The lender isn’t going to overstretch your line of credit, and whatever they are willing to give you automatically becomes your ceiling when you go to the dealership. This helps you avoid surprises and to find a car that you know you can definitely afford. If you can afford a loan, then you can certainly afford any car that falls within that loan price.

Problems with Direct Lending

  • There’s little to no room for negotiation when it comes to the direct lenders. They may have to compete, but unless you have a very strong credit profile, you’ll end up just having to take whatever terms they ultimately give you and you won’t be able to find much wiggle room. Dealerships are generally more responsive to negotiation.
  • You can’t get the same zero-percent loans that you can from the dealership. Financial institutions rely on the interest they gain from you to make their profits. They’re not like dealerships, able to make money from different channels just like that.
  • If you fail to get pre-approval for an auto loan from a direct lender, then that can make your experience just as tense as when you hope beyond hope that the dealership will approve your finance deal in the end. The biggest benefits of direct lending seem to rely quite heavily on customers getting pre-approval so they can feel more assured in their plans.

Conclusion: Read the Terms and Conditions; Avoid the Pitfalls

At the end of the day, the best thing you can do when it comes to car financing is to always read the fine print and never let yourself get taken in by marketing hype. The lending industry is so lucrative, and there have been too many horror stories over the years in which predatory lenders trap people in troubling cycles of debt.

A car is a costly item. It will never turn a profit for you. It will only ever cost you, from the monthly lease/repayment amount, to gasoline, maintenance, insurance, tax and other considerations. A car is like having another child, but far less rewarding and meaningful in the long term. Still, it’s a practical consideration that nearly all of us need to factor into our lives.

When taking on automotive financing, always read the terms and conditions, work within your budget, don’t overstretch yourself financially, and remember that when an offer really seems too good to be true, it just might be.

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