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  • Understanding Car Financing

    Buying a car is something most of us do because we can't work or go to school without our own reliable transportation. Yet cars are expensive―both new and used. If you are like most drivers, you'll need to finance your car purchase. In other words, you'll need to take out a loan and pay interest.

    Financing a car is common, but that doesn't mean you shouldn't understand the various financing programs. There are a lot of options―and even pitfalls. A little studying and research on your part will help you strike a better financing deal.

    Loan Basics

    Loans come in simple or front-loaded interest types. A simple interest loan calculates the interest on your entire loan and then breaks the interest payments into equal monthly amounts.

    Front-loaded interest loans are better for the lender because the interest you pay is greater at the beginning of the loan and tapers off near the end. What happens if you pay off the loan early or default? The lender has already received a larger portion of the total interest on the principal loan amount.

    You will be offered an interest rate based on several factors. Among them:

    • Your credit rating
    • The loan term (how long until you pay it off)
    • The region you live in
    • The age of the car

    Your credit rating is one of the most important factors influencing your car financing. It is always a good idea to review your credit rating before applying for a loan. There is as much to learn about credit scores as there is about loans.

    For example, your score changes every time someone requests a copy of your credit report. The bottom line is: Know your credit rating before you negotiate financing.

    Most car loans are for 60 months, or five years. Generally, the longer the term, the higher the interest rate. Short-term loans have lower interest rates but higher payments, because the payback period is shorter for the same amount of money.

    The total loan amount is the single most important figure in your loan agreement. You will be focused on the interest rate and the monthly payment, but don't lose sight of the total amount financed, because this is what your interest amount will be calculated on.

    Your negotiations when you buy the car will determine the total loan amount. Trade-in allowances and rebates can reduce your net purchase price. The selling price itself, as the actual basis for your net purchase price, is also critical to your loan amount. Negotiate the best purchase price before you begin to deal with add-ons and allowances.

    Sometimes the market changes, or maybe you paid too much for the car you have. When your loan amount exceeds the amount your car is worth, then you have an upside-down loan. If you borrow too much, you could end up with an upside-down loan.

    Sources of Financing

    Once you have an idea of what your car budget is, you can decide on a loan program. The specifics of your auto financing will depend on where you go for the loan. Dealerships, banks, credit unions, friends, and even online lenders can lend you money for your car.

    Dealerships are the most convenient when it comes to financing because they are open long hours and can usually run your paperwork through while you are in the showroom. What you gain in convenience, however, you lose in interest rates and total financed amount.

    The interest rate a dealership offers you is usually marked up, making it higher than most competitive rates. Dealer financing is often front-loaded, meaning you pay more interest up front. And, add-ons are very common with dealer financing.

    Add-ons are offered to you when the loan package is being put together because they can be easily rolled into your total loan amount. Be alert when considering dealer financing, because they will sell you extended warranties, VIN etching, and insurance―all while charging an application fee.

    Banks and credit unions are good sources of car financing because you probably already have a relationship with a local bank. Perhaps not quite as convenient up front (the application process could be a few days long), bank loans can be more convenient in the long run because you can consolidate your banking with one branch or bank.

    Interest rates at credit unions or banks are very competitive, though still based on your credit score. The most common car loan from these sources is a simple interest loan with a small down payment. Finally, the bank will tell you if they agree with the purchase price for the vehicle and whether it reflects current market conditions; this can prevent you from making a poor purchase choice.

    Home equity loans can also be a good source of car financing because they have tax advantages. However, the disadvantage is that once you take a home equity loan for your vehicle, you will have linked your car to your home. This can be a risky financial move.

    When it comes to convenience, the Internet is available all day, every day. There are lenders online who can process your car loan quickly and effectively. Consider shopping online for a car loan with competitive interest rates and favorable terms.

    You might even want to borrow the money from a friend or family member. Perhaps you don't have credit established yet because you are a student, or maybe you don't want to bother with a bank because the amount isn't that much (but you still don't have it in your savings). Why not borrow from someone you know and pay them the interest instead of paying the bank? It will help your relationship to be clear about the deal so that no hard feelings develop. Sign a contract.

    Understanding Incentives

    Incentives can really change the deal you negotiate, which will also change your car financing. For example, 0% APR is very attractive and could motivate you to buy a new car―which is exactly what the car manufacturers want you to do.

    Your credit score will determine whether you are eligible for the 0% APR financing. You will probably have to give up any cash rebates and take a short term on your loan if you elect this incentive. This offer is processed at the dealership, so watch out for add-ons that you normally wouldn't choose.

    Cash rebates are offered from the factory to you, the consumer. Regardless of what purchase price you negotiate with the dealer, your factory rebate is yours. Understanding how the rebate applies to you will give you confidence in negotiating with the dealer. Again, the rebate is between you and the car manufacturer―not the dealer.

    Finally, some car manufacturers offer specials to target groups like recent graduates. These incentives are not always well advertised, but your dealer should be aware of any that could apply to you. Research you do on the Internet might also uncover special deals on certain makes and models.

    Buying a car can be very exciting, and selecting the car for you is a very personal choice. However, you need to live with the financing for quite some time. And the more you understand before you start the purchasing process, the better able you'll be to get a good interest rate on the right loan amount. After all, you have to make the payments, and you'll want them to fit in with all the other items in your budget.