Car Financing for Beginners

Al Hearn

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One of the most misunderstood concepts about leasing or buying a new car with a loan is how the financing really works. We'll say it again later, but the key concept to understand is that dealers do not finance car leases and loans. Repeat: New-car dealers do not finance cars. However, dealers can affect what you pay for financing.

Dealer always sell for cash

Car dealers are independent business people who have an authorized franchise with one or more car manufacturers. They do not work for the manufacturer. There are no manufacturer-owned car dealerships. In some cases, a large dealership may own multiple dealership stores in various locations. These stores may sell the same brand vehicles, or different brands. Dealers buy cars from the manufacturer, usually with large loans from a bank or finance company. The bank charges dealers interest on these loans. Dealers have to sell cars to pay off these loans and associated interest, as well as cover other expenses of running a business.

Dealers always get cash for their cars, whether it's directly from the customer, or from a finance company or bank who has loaned a customer the money. A common misconception is that dealers give cash customers a discount. This is not true because dealers generally make more money on financed loans or leases — in the form of commissions or boosted interest rates.

Dealers don't finance leases and loans

When a dealer leases or sells a car to a customer, he has finance companies or banks that he works with to provide his customers the financing they need. Most dealers use the car manufacturer's “captive" finance company, such as GMAC, Ford Motor Credit, and American Honda Finance. Dealers arrrange financing on customers’ behalf — as a service. Customers can arrange their own financing if they choose.

Key point: Dealers do not finance leases and loans. Dealers do not approve customers for leases or loans. Dealers do not process leases or loans or take payments on leases or loans. Dealers simply take lease and loan applications and try to arrange financing for customers.

Dealers use independent finance companies or banks on customers’ behalf

A dealer may do a cursory preliminary check of a customer's credit history using one of the three major credit reporting agencies. This NOT for loan or lease approval, but only to determine if the customer has such serious credit problems that it would not make sense to continue with the transaction.

Remember, the dealer is NOT the finance company — he cannot approve customers for loans or leases. The finance company or bank to which the dealer sends the lease or loan application will do their own check and look at not only credit history and payment history, but credit score, and debt-to-income ratio. This credit worthiness check is much more thorough than the simple check that the dealer may have done.

What you'll pay - your credit score When a finance company or bank checks your credit score, you'll be classified in one of three categories. First, you could be rated a “prime" customer, or “A" tier. This means your FICO score is higher than 680. You qualify for the best interest rate.

If your credit score is between 620 and 680, you are “near-prime" and will pay as much as 5% higher interest rate than someone with a better score.

If your score is below 620, you are considered “sub-prime" and will almost certainly have difficulty finding a bank or finance company who is willing to give you a loan or lease. If you find one, your interest rate will likely be extremely high.

Dealers can change your interest rate

One of the potential “hidden" fees when buying or leasing a car is a markup that dealers can add to your interest rate, even when you have a good credit score. . Say the normal interest rate from the finance company used by the dealer is 6.0%. The dealer marks up the rate by a percentage, say 2.0%, making your real rate 8.0%. This markup is never mentioned anywhere in the documents you sign. Car dealers claim the practice is justified to cover the cost of their brokering customers’ financing. In fact, it's additional profit or simply making up for concessions made to the customer somewhere else in the deal.

Automotive News reports that a number of companies such as DaimlerChrysler Services, Honda Finance, and GMAC have settled on a 2.5% markup limit agreement. California now has a law that sets a 2.5% markup ceiling for most car loans. So it seems that 2.5% is now the magic number in the industry.

A common question from automotive consumers is, “Can I negotiate my interest rate?" In most cases you can try to negotiate the markup, but not the base rate, which is set by the finance company based on your FICO score. In the past, there was no good way to know how much the car dealership was marking up the rate but, now, with the recent “agreements" and laws, we can assume the markup rate is going to be as much as 2.5% added to the base rate. Lease rates are particularly difficult to negotiate because the interest rate is expressed as “money factor" (see the discussion of lease finance fees in our Monthly Lease Payments article), and the rate doesn't appear in your lease contract.

Be aware that not all dealers mark up interest rates, but it seems to be a growing practice. Also remember that your base rate will be determined by how a finance company values your credit history and your credit score. This is why is it so important to understand how credit scoring works. A low score or mistakes in your credit history report can easily force a high base rate, even without markup. Therefore, knowing your credit score and shopping around for the best rates is always a good thing to do.

Dealers may check your credit, but it matters little

Many customers mistakenly assume that when the dealer says he has done a credit check and lets the customer sign papers, that the deal is done and everything is legally wrapped up. Not true. Customers often believe that they can somehow keep a car that they haven't paid for just because they have signed papers or that there is some minor technical mistake in their contract. This is also a misconception.

What you sign and what it means

When a customer leases or buys a car with a loan, he or she signs papers that essentially say the following: " I agree to lease or buy this car, using funds that might be loaned to me by a finance company or bank (if they approve me) that the dealer will attempt to arrange for me and, if those funds are not approved by a finance company or bank, the deal is void unless the dealer can find another finance company that will approve me. If the funds are approved, the finance company or bank will pay the dealer directly with those funds that have been loaned to me. The finance company or bank will then work directly with me to arrange monthly payments to repay that loan or lease. I understand that the dealer will have then been paid in full for his car and will no longer be involved in the lease or loan. "

If your lease or loan is not approved

The finance company or bank can find problems in the customer's credit history/score or debt-to-income data that makes them flag the application as high risk. They can then ask the dealer to inform the customer that the application was not approved, or that additional money is required, or that a co-signer is needed in order to re-submit the application for approval. Finance companies and banks work through the dealer; they do not work with the customer directly until the payment book arrives after approval.

With leases, a finance company will sometimes ask for a down payment when there was none initially, or may ask for a larger security deposit, possibly when there was none initially. Often, this will allow the payment to remain the same even though the overall cost of the deal has gone up.

If the finance company or bank does not approve the customer's lease or loan, they don't pay the dealer for the car, and the car still belongs to the dealer, even though he may have already allowed the customer to drive the car home a couple of weeks ago. If the dealer doesn't get paid, he will want his car back, regardless of any contracts the customer may have signed.

What choices do you have?

First, the customer should always know their own credit history and FICO score before ever setting foot in a dealer's showroom. This way, there won't be any surprises later. Second, the customer can ask the dealer if he works with other banks or finance companies who might be willing to approve the loan or lease. Third, the customer can always shop for their own lease or loan financing and get pre-approval for a spending limit.

Al Hearn is founder, owner, and operator of two popular automotive consumer web sites, Lease Guide and Used Car Advisor , which provide free auto buying, selling, leasing, and financing advice.


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