What Is Car Finance and How Does It Work?

What’s the best way to finance a new or a used car? Since auto loans are typically the second or third biggest financial commitment most people will ever take on – only home mortgages and student loans tend to be larger – it pays to understand your options and choose the alternative that will save you the most.

The best and least expensive way to pay for a car is to avoid interest rates and fees altogether by paying for it in cash. While some people have saved up enough to do this – especially if buying a relatively inexpensive used car – in today’s high-priced auto world most car buyers cannot afford to pay for their vehicle outright. Instead, they finance their purchase by taking out a loan.

Loans for financing a car usually come from one of two sources – either the car dealer or a bank. There are pros and cons to both.

When you finance your car through a bank or credit union, the lender runs a credit check and, if you pass, gives you a quote and a letter of commitment that you can take to a dealer. This has two advantages. First, you are now pre-approved for a loan and know exactly how much you can afford to spend. Second, a car salesperson will be less inclined to urge you to buy a vehicle that costs more than the loan for which you’ve been approved.

Another big plus: The interest rate on a car loan from a bank is frequently lower than what you would get from a dealer. That’s because most dealer loans actually come from a bank. To make a profit on the loan, the dealer has to mark it up by increasing the rate. 

On the downside, the quote you get from a bank isn’t locked in until you provide it with the details about the car that you’re buying. This final approval process can sometimes lead to delays and changes to the initial offer. In other words, you could end up with a higher interest rate than what you were expecting.

Another thing to keep in mind is that banks often charge higher rates on loans for used cars than for new ones and may restrict your choices by placing limits on the age and the mileage of the vehicle that you buy.

With dealer-arranged financing, the process is reversed. After you settle on a car, the dealer has you fill out a credit application, which it submits to multiple lenders on your behalf. This saves you a lot of legwork, and you still get to compare the rates and terms of different loans. However, the dealer may be marking up the loans and not sharing information about all of your car finance options.

On the other hand, dealers sometimes offer promotional financing on certain current model-year vehicles that can be as low as 0% APR. This can be a great deal – if you qualify – although you’ll have to spring for the cost of a new car. 

There are also dealers who offer in-house car financing for people with bad or no credit. But the interest rates and down payment requirements for these loans are higher than for loans you would get elsewhere, and if you fall behind in your payments your car is more likely to be repossessed. 

Advantages of Financing a Car Through...