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Financial Education

Loan to Own

Car Loans

There are many decisions you must make before purchasing or leasing a car. This lesson will focus on financing and leasing, but some other points you need to consider when looking for a car are:

• Should you get a new or used car?
• Should you lease or buy?
• How much can you afford?
• Should you trade in your old car?

The Federal Trade Commission, FTC, has various publications that can help you buy a car and make sure you get the best price. At the FTC website, you can access brochures such as:

• Buying a New Car – which includes tips on how to choose a car, information on negotiating the price, and considerations when financing a car, and

• Buying a Used Car – which includes information explaining different payment options, dealer sales, private sales, and warranties.

You can also call the FTC at 1-877-FTC-HELP (1-877-382-4357) to request a copy of their brochures.

Car Loans vs. Leases

You should evaluate both the costs and the benefits before deciding whether to buy or lease a car.

• One of the main differences is ownership. When you lease a car, you do not own the car. Leases are basically long-term rental agreements. You make monthly payments to the dealership. These agreements might last 2-5 years. If you obtained a car purchase loan, you would own the car at the end of the loan.

• The second difference is in wear and tear. Most leases charge for exceeding "normal" wear and tear. If you buy, you would not have any additional costs for wear and tear in your purchase agreement.

• The third difference is the monthly payment. You will have lower monthly payments if you lease a car rather than if you finance a car. The reason monthly lease payments would be lower than monthly loan payments is because you are not purchasing the car. The dealership owns the car. Once the lease agreement is over, you turn in the car.

Although you have the option of purchasing the car at the end of the lease, the total cost would be more than if you had initially bought the car. On the other hand, with a car loan you actually pay for the purchase of the vehicle. Once you finish making the payments, you own the car.

• The fourth difference is mileage. Leases usually restrict the number of miles you drive each year. You must pay the dealer for each additional mile driven as stated in your lease contract.

An example of this is having a two-year lease that has a 24,000-mile restriction. Each mile driven over 24,000 will cost you $0.15. This can add up if you drive a lot. You might be surprised how quickly miles can add up. Driving 2,000 miles over the limit would cost you $300 (2,000 x $0.15 = $300). However, if you buy a car, there are no mileage restrictions.

• Lastly, there is also a difference in auto insurance rates when you lease. Auto insurance usually costs more if you lease than if you purchase a car.

Most car leases require you to purchase higher levels of insurance coverage. Make sure you find out what the requirements are and get an estimate from your insurance company before you decide on leasing.

Understand the differences and carefully consider all the costs and benefits before deciding whether to buy or lease.

Car Loans

Getting a car loan is also referred to as financing your car. A car loan can be used to purchase a new or used car. Your car becomes your collateral for the loan, which means the lender will hold the car title until the loan is paid off.

The title indicates who owns the car. If you do not pay the loan off, the bank can repossess, then sell the car, to get the remaining loan amount or proceeds back.

New car loans typically last 3-7 years, while used car loans last 2-4 years.

If you decide to purchase a car, you should know exactly how much you are paying for the car and the exact amount you need to borrow. A car loan might be one of the biggest expenses you have.

When considering a car loan, be sure to shop around for the best deal before you make a commitment. You can obtain car loans from:

• Banks
• Credit unions
• Thrifts / Savings & Loans
• Finance companies
• Dealerships

Most lenders can pre-approve your car loan. This means the financial institution calculates how much money you can borrow to buy your car. This is typically a free service and does not obligate you to accept a loan offer from the institution.

Dealers sometimes offer low loan rates for specific cars. To get the lowest advertised rate, you might have to:

• Make a larger downpayment
• Agree to a short loan term, usually three years or less
• Have an excellent credit history, and
• Pay a participation fee

A participation fee is a fee that some dealer finance companies might charge to obtain a loan. For example, although a 2% APR rate might be advertised, the company might charge you a participation fee of $200 up front to get the low rate.

The Best Financing

Sometimes, dealers try to make extra profit through the loan process. A dealer might have business relationships with many different lenders, so when you ask for dealer financing, the dealer might call several lenders.

Instead of picking the lender with the best rate for you, some dealers might pick the lender that makes the most profit for the dealership. For referring you and other customers, the lender might split part of the profit with the dealership.

Here’s an example:

• Sam assumed the dealer would give him the best deal and did not shop around for a car loan. After all, he was able to negotiate the best price for his car at this dealership -- $6,000 for a used pick-up truck.

• The dealer told Sam that if he put $1,000 as a downpayment, he could get a car loan for 16%. Sam accepted the agreement without researching other possibilities.

This is what really happened:

• The car dealer had called several lenders in the area for Sam. Lender A told the dealer that Sam qualifies for a $5,000 car loan for as low as 10%.

• However, Lender A had an agreement with the dealer stating that for any rate over 10%, the dealer would split the profit. This gives the dealer an incentive to work with Lender A and an incentive to charge Sam a high interest rate.

Auto Financing Tips

• Shop around for auto financing before going to the dealer. Get pre-approved for the loan.

• Compare APRs from local banks, credit unions, websites and newspapers.

• Order a copy of your credit report and correct any errors a few months before shopping for a car.

• Make the largest downpayment you can. Beware of a low downpayment or long repayment plans. The more you borrow and the longer you take to pay the loan, the more interest you pay and the more your car will cost you in the end. Additionally, if you have to sell your car in the first few years, you could owe the lender more than the car is worth.

• Consider paying for the license and registration, title search, and taxes separately rather than financing them. This can reduce the amount of interest you will pay.

If you are going to apply for a loan at the dealership, make sure you first negotiate the best price on the car. Beware of dealers who insist on asking you how much you can you afford every month. These dealers might be interested in making you stretch out the term of the loan to make the loan sound more affordable. However, by extending the length of the loan, your total cost will increase. Be aware of penalties. Some lenders might charge you for paying off your loan early. If you need to give the dealer a deposit, make sure you know whether you will get the money back if you change your mind. It is best to get this in writing.

Remember service contracts, credit insurance, extended warranties, and other options are not required and can be costly over the term of the loan.

Be aware of ads that promise loans for people with bad credit. These deals often require a higher downpayment or have a very high APR.

Title Loans

Title loans may sound like a good way to get quick cash, but it can be very costly.

Here is a title loan example: Michael wanted to get a one-month $500 loan to pay for an unexpected medical expense. He saw a television commercial that mentioned, ‘If you have a car, you can get a loan.’ Michael had a car worth about $2,500, so he decided to apply for the loan. He went to the finance company he saw on the commercial. They loaned him $500 with a 20% monthly interest rate. Note that the finance company did not advertise the APR. The finance company took his car title as collateral and Michael kept the car.

With a 20% monthly interest rate on the $500 loan, Michael owed $600 at the end of the month -- the $500 loan plus $100 in interest. Michael could not repay the $600 at the end of the month. The lender could have repossessed the car. However, the lender gave Michael the option of just paying the $100 of interest and gave him until next month to pay the loan. At the end of every month, Michael could not come up with the $600, so every month the lender accepted his $100 interest payment.

By the end of one year, Michael had paid $1,200 in interest for his $500 loan -- $100 every month = $1,200! This equates to a loan with a 240% APR. This is an expensive way to borrow money.