How to Finance a Car

So you’re ready to buy a car.  Congratulations!  If you’re like 90% of Americans, you’ll seek to finance your new car, as most of us don’t have an extra $30,000 in cash under the mattress. There is a lot to know about how to finance a car but here are some pointers.

Simply put, financing a car means taking out a loan to buy your new (or used) vehicle.  Such loans can be arranged through your auto dealer, who can sign you up for a loan through their company’s financial arm, such as Toyota Financial Services.  Potential car buyers can also go directly to a bank, credit union or other financial institution for a loan and finance a car. 

Financing a car can be challenging.  The bank or dealership will need to know your ability to repay the loan. They will want to see your income, and run a credit check to see your ability to borrow.  Young people sometimes will need a co-signer who will help guarantee the loan, such as their parents. 

The first step in financing a car is to write down your income and expenses, so you can see how much you can spend on a car. Let’s say you make $48,000 a year, or $40,000 ($3330 per month) after taxes.  Say your rent and utilities are $900 a month, food spending $500 a month, entertainment, travel, credit card bills, insurance and medical another $600 a month, and miscellaneous spending (and hopefully some savings) comes to $400 a month, for a total of about $2400 per month.  Let’s say you’ll need $400 a month for the upkeep of the car, such as insurance, gas, registration, etc, bringing your monthly expense total to $2800.  That leaves you with about $530 a month to spend on financing a car and make car payments.

Based on these numbers, you could probably afford a $20,000 car, if you put down $4000 (cash or trade-in) and financed $16,000 at 5% per year.  Your monthly payment? $368. 

Only you can know what your budget is and what your needs are.  Don’t forget to research the cars you’re interested in on Autobytel.com before you start shopping, and make sure your budget includes any ‘must-have’ options.

To finance a car, the buyer generally puts down a certain percentage of the purchase price, (often 20%) then finance the rest. The down payment can come from several sources when you finance a car.  The most obvious is cash, so it’s helpful to bring a bank statement to the dealer showing you have enough for the down payment. 

Part of the down payment to finance a car can also come from dealer or manufacturer ‘cash back’ or rebate offers.  So if the $20,000 car you want has a $1000 rebate, you may only have to come up with $3000 in cash for the $4000 down payment.  Just be aware manufacturers usually offer either a cash rebate or promotional financing.  You’ll have to pick which you want.

Finally, a down payment can also come from trading in your old car.  If that $20,000 car has a $1000 rebate and if your trade-in is worth $3000, you may be able to put down your down payment without actual cash.  However, you’ll usually do better selling your car privately, then using the cash as the down payment on your new wheels.  If you do decide to trade in, it’s best to discuss the possibility of a trade-in only after you’ve negotiated the best possible price for your new car and after you’ve researched the value of your old car.

With loans, as with cars, the first rule is to shop around.When financing a car, banks and credit unions can offer excellent deals, and getting a loan preapproved before you start looking for a car is like shopping with cash. 

On the other hand, dealers often have promotional financing on certain models available from the auto manufacturer to help you finance a car. Dealers are experienced in getting borrowers with special needs, like first-time buyers and recent college graduates, approved.

Finance companies often have the highest rates and worst terms, but may be a last resort for borrowers with bad credit when financing a car.

Using a home equity loan to finance a car may look appealing, but beware.  Taking money out of an asset that’s supposed to appreciate (your house) to pay for something guaranteed to depreciate (your car) is not recommended by financial experts.  Home equity loans are also more difficult to get since the housing crisis wiped out the equity in many homes.  Unpaid home equity loans (sometimes called ‘second mortgages’) have contributed to many foreclosures.

Loans are commonly available for three, four, five, even seven year (84 month) terms.  Obviously, (without taking interest rates into account) the shorter the loan, the higher your monthly payment will be.  The longer the loan, the lower the monthly payment.

Let’s take a look at an example.  Let’s say the car you’ve picked out costs exactly $20,000, and you can put down 20%, or $4000, (cash, rebate or trade-in) towards financing a car. 

The $4000 down payment leaves $16,000 to be financed. If you finance a car for three years (36 months) at 5%, your monthly payment will be a stiff $480.  Financing a car for six years (72 months) at the same 5% rate brings the monthly payment down to a reasonable $258.  However, you’ll pay more interest over time.  In addition to repaying the $16,000 principal, the six year loan will cost you a total of $2,553 in interest; the three year loan only $1,263.

Unfortunately, in the real world of car finance, things aren’t so simple.  Generally the longer the term of your loan, the higher the interest rate.  (The longer you use their money, the more the bank wants you to pay for the privilege.) 

An American manufacturer recently offered special financing on a popular small SUV.  The three-year financing rate was 2.9%, while the four year rate was 6.5%.  At 2.9% for three years, the monthly payment on a $20,000 loan would be $581.  You’d pay just $907 in interest over the life of the loan.  At 6.5% for four years, the monthly payment would be $474, while the total amount of interest you’d pay over those four years would be $2,766 when financing a car.

Loan rates are often expressed as APR, or annual percentage rate.  The APR refers to the annualized cost of credit expressed as a percentage in the finance agreement.  Keep in mind that a loan may have a higher APR than its rate (a 5% loan might have a 5.5% APR, for example) depending on any additional fees rolled into the loan. One such cost might be ‘credit insurance’, to pay off your loan if you die or become disabled.  Try to avoid efforts to sell this to you.

When financing a car, always shop around for the best deal, comparing the annual percentage rate and the length of the loan.  And don’t focus only on the monthly payment. The total amount you’ll pay depends on the price of the car you negotiate, the APR, and the length of the loan.