How Does Car Financing Work?
Buying a car can be confusing by itself – what’s the difference between MSRP and base price? What does torque mean? Do you really need the sport package? But when you add in financing, it’s no wonder most of us would rather go to the dentist than to the car dealership. Getting a car loan can be confusing, but we’re here to help. In this blog post, we’ll explain how car financing usually works and what you need to watch out for when you get your next car loan. As always, if you have any questions, please don’t hesitate to contact us.
How Car Financing Usually Works
Auto financing comes in two primary flavors: direct and indirect. A direct loan is one that the borrower arranges with a lender directly. So if you go to your own bank or credit union to apply for a loan and they hand you a check to bring to the dealership, you’ve got a direct loan.
Indirect financing is facilitated by a dealership. Legally, an indirect “loan” isn’t really a loan; when a car buyer obtains financing arranged by a dealership, the buyer and dealer sign a Retail Installment Sales Contract, not a loan agreement. (That might not seem important, but certain regulations apply only to loans, not sales contracts).
Usually, the dealer knows in advance which lender will buy the contract and sets the interest rate (known as the contract rate) accordingly. The dealer will sell or assign the contract to that bank, credit union, or other financial institution. The borrower then pays off the loan with the financial institution the same as for a direct loan. So if you go into the dealership and walk out owing money to Wells Fargo or Bank of America, you’ve gotten indirect financing.
How Car Financing Benefits the Dealership
Car dealerships make a lot of money on financing markups – and that amount keeps growing. (If you want to keep track of how much markups have grown over time, make sure you check out our Markup Index, which we update monthly). That markup comes from two sources: markups on the interest rate you pay for your loan and markups on ancillary products you choose to buy with your loan.
Loan Markups
Dealers make about $900 on the average new car loan by marking up the interest rate you’re offered from the lenders. How does that work?
Let’s imagine you go to the dealership to buy a Ford F-150. You can’t afford the $30,000 price in cash, so you ask the dealer to help you secure a loan. The dealer typically has relationships with a few financing sources, including banks, the manufacturer’s captive financing arm – Ford Motor Credit in this example, and credit unions. The dealer will submit a finance application on your behalf to those lenders. Let’s say you’re approved for a 4% interest rate at Pentagon Federal Credit Union, a 5% at Ford Motor Credit, and a 10% at Wells Fargo. The dealer might turn to you and say, “Great news! I’ve got you a 7% interest rate from Ford Motor Credit.” Wait – what just happened?
The dealer decided to show you the Ford Motor Credit offer even though you could have gotten a better rate elsewhere and with the dealer’s markup already baked in. Is that legal? Yes. The dealership has no obligation to tell you what rates you qualify for. If you want to know, you’ve got to do your own loan shopping, outside the dealership. The dealership also has no obligation to tell you they’re marking up your loan, let alone by how much. So if Ford Motor Credit lets the dealer add two percentage points to your loan, and Pentagon Federal Credit Union doesn’t, the dealer can choose to offer you Ford Motor Credit’s loan and ignore any other offer. Every lender sets a different policy of how much it will allow dealers to mark up a loan, but the standard is around 1 or 2%.
Ancillary Product Markups
Dealers make even more money by marking up the extra products they sell with loans than they do on loan markups, on average. Those products include vehicle service contracts (sometimes known as extended warranties), GAP waiver policies, Tire & Wheel protection plans, and rustproofing. (Not sure if those products are worth buying at all? At Outside Financial, we think certain ancillary products can be valuable, if you buy them at the right price and you know what you’re getting. We offer a lot more info on protection products here).
Ancillary product markups can vary wildly because most car buyers don’t know what a fair price should be for a vehicle service contract or GAP waiver policy. The only limit on how much dealers charge is what they can get lenders to cover with the loan, since most car buyers don’t want to pay out of pocket for extras. Lenders usually set a maximum amount for the loan tied to the vehicle’s value. For example, most lenders won’t allow you to borrow $40,000 if you’re buying a $30,000 car. That’s because if the lender has to repossess the vehicle, they won’t be able to resell it to recoup the money they lent out. Those kinds of limits are tied to the loan-to-value ratio or LTV, which compares how much you’re borrowing from the lender to how much the vehicle is worth. As long as all of the ancillary products fit within that LTV cap, though, the dealer is free to charge whatever the buyer agrees to pay.
How Securing Financing Before You Buy the Car Benefits You
We recommend securing your financing before you go to the dealership for two reasons: one, it’s the only way to know what rates you qualify for; and two, you can avoid the dealership markup and save yourself a lot of money.
One big misconception that a lot of car buyers have is that all lenders are the same, so there’s no point in shopping around for a loan. Why is that wrong? Loan rates can vary widely, even for the same borrower buying the same car. Each lender sets its underwriting criteria according to its own proprietary formula, which means that you could be offered a 4% rate by one lender, a 14% at another, and denied by a third. The only way to know what rates you qualify for is to apply with multiple lenders. Keep in mind that some lenders will do a hard inquiry (or “hard pull”) of your credit in order to consider your application. A hard pull will drop your credit score by a few points, but multiple hard pulls for a car loan will only count against you once within a short period of time. That means you can shop around at different lenders for a loan without any penalty.
Arranging financing outside the dealership also lets you avoid the dealer markup on the loan and other products. Many lenders, especially credit unions, sell products like vehicle service contracts at cost or close to it. If you secure direct financing and your dealer offers to match your loan rate, just make sure you compare the total cost of the financing package you’re offered, including ancillary products. It’s not worth saving a little on the interest rate if you spend way more on a GAP waiver.
What Should I Do Now?
If you’re in the market for a car, your first stop should be your bank or credit union. Figure out how much car you can afford, and get pre-approved for that amount. Once you’ve secured your direct loan, then you can go to the dealership and car shop with confidence. Good luck, and let us know how we can help!