What Is Car Finance and How Does It Work?
5 Min Read | Last Updated: April 1, 2022
This article contains general information and is not intended to provide information that is specific to American Express products and services. Similar products and services offered by different companies will have different features and you should always read about product details before acquiring any financial product.
Learn the differences between bank and dealer auto loans, and how your down payment and loan length affect your total cost of owning the car.
At-A-Glance
- When financing a new or used car, you usually borrow from one of two sources: a bank or a car dealer.
- Either way, the size of your down payment and the length of the loan both influence the interest rate you can get and the total cost of your car financing.
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.
Financing Your Car through a Bank
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.
Financing Your Car through a Dealer
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...
| A Bank | A Car Dealership |
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Getting the Best Car Financing Means Making Tradeoffs
The interest rate – also referred to as the annual percentage rate or APR – that you pay on an auto loan will also vary depending on the term of the loan and the size of your down payment. For more insight on APRs, read “What is APR and How to Calculate It.”
Loan terms are the length of the loan, usually expressed in months. Terms of 36 to 48 months used to be the most common, but as cars have gotten more expensive, loan terms of 60 months or more are now widely available. Your down payment is the amount you pay up front to purchase your vehicle. The difference between your down payment and the price of the car is the amount you must finance, aka the loan principal.
Since shorter loan terms and larger down payments reduce the lender’s risk, car buyers who put more down and agree to take less time to pay off what they borrow receive lower interest rates and wind up paying less for their vehicles. The more money you put down on your car, the less you will have to borrow – and the smaller your loan, the smaller your monthly payments. Paying off the loan more quickly, however, means paying more each month, so deciding on the best car financing approach for you is about more than just getting the lowest possible rate. You also must be able to afford the size of the down payment and the monthly payments that you will need to make to get the rate that you want.
The Takeaway
Figuring out the best way to finance your car requires some homework. You need to shop around for the bank with the best interest rate and then compare it with whatever finance arrangement is on offer from the dealer. But you also have to decide how big a down payment you can afford and how large a monthly payment you can carry. Once you’ve determined this, you can borrow as little as possible for as short a time as possible in order to get the lowest rate and save as much as possible on the total amount you will pay for your vehicle.
Elliot Kass is a journalist who has covered global business and technology from New York, London, and San Francisco for more than 30 years.
All Credit Intel content is written by freelance authors and commissioned and paid for by American Express.
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