How does car financing work? How do car loans and leases work?
One of the most misunderstood concepts about buying or leasing a new car is how auto financing really works. Dealer financing, specifically, is often misunderstood.
We’ll explain it later, but the key concept to understand is that car dealers do not finance car loans and leases. However, dealers can most certainly affect how you finance and the interest rate you pay for financing.
Dealers always sell for cash — not necessarily your cash
Car dealers are independent business people who have an authorized franchise with one or more car manufacturers. They do not work for the manufacturer; the manufacturer does not own the dealership.
Dealers buy cars from the manufacturer, usually with large “floor-plan” loans from a bank or “captive” finance company. The bank charges dealers interest on those loans. Dealers have to sell cars to pay off those loans, with interest, as well as cover other expenses of running a business.
When a dealer sells or leases a car, he always receives cash, whether it’s directly from the customer, or from a finance company or bank who has loaned a customer the money.
A common misconception is that dealers would rather get cash directly from a customer, bypassing the financing step, and that cash customers get better deals. This is not true. In fact, dealers typically get a commission or “finders fee” on car financing provided by banks or finance companies and therefore prefer that customers finance or lease. They make more money that way.
Dealers don’t finance car loans and leases
Dealers are not bankers. They don’t have a loan or lease department. They do not approve loans, although they often check customer’s credit. They do not directly finance cars they sell or lease. Instead, they have preferred finance companies or banks that they work with to arrange financing for customers, as a service Most dealers use the car manufacturer’s “captive” finance company, such as Ford Credit, and Honda Finance, although some may use a distributor’s finance company (e.g. Southeast Toyota Finance) or a large national bank (e.g. Ally Bank).
Car buying customers do not have to accept dealer-arranged financing. They can find their own financing with banks or credit unions if they choose. This is not true for leases, not since the Great Recession.
Dealers do not process leases or loans or take payments on leases or loans. Dealers simply take customers’ finance applications and pass them along to a finance company. Technically, they “sell” customer loans and leases to the finance company. Once financing has been approved and arranged, the dealer is paid and is out of the picture.
Dealers pre-approve car financing
A dealer may do a cursory preliminary check of a customer’s credit score using one of the three major credit reporting agencies. This NOT for loan or lease approval, but only to determine if the customer has such serious credit problems that it would not make sense to continue with the transaction. Dealers are often guilty of pre-approving customers who have poor credit, in hopes that somehow, someway, his finance company will approve them.
Remember, the dealer is NOT the finance company — he cannot approve customers for loans or leases. The finance company or bank to which the dealer sends the lease or loan application will do their own check and look at not only credit history and payment history, but credit scores, and debt-to-income ratio. This credit worthiness check is much more thorough than the simple check that the dealer may have done.
What you’ll pay – your credit score
When a finance company or bank checks your credit score, you’ll be classified in one of three categories. First, you could be rated a “prime” customer, or “A” Tier or Tier 0/1. This means your credit score is higher than about 700 or 720. You qualify for the best interest rate and should have no problem being approved.
If your credit score is between about 620 and 680, you are “near-prime” and will pay as much as 5% higher interest rate than someone with a better score.
If your score is below about 620, you are considered “sub-prime” and will almost certainly have difficulty finding a bank or finance company who is willing to give you a loan or lease. If you (or your dealer) find one, your interest rate will likely be extremely high.
You should always know your current credit score ahead of time before you visit a dealer to buy or lease a car, to avoid embarrassing surprises.
What’s your FICO score? Find out now when you check your credit report for $1 at Experian.com! Knowing your credit score will help prevent problems. Don’t let a dealer surprise you with information about you that you don’t already know about yourself.
First-time buyers or leasers with little or no established credit history may have to use a co-signer who has a good credit history. The co-signer’s credit allows financing to be approved but otherwise plays no part unless the buyer or leaser defaults. Cosigners have no part in vehicle ownership or registration. Cosigners are not co-owners, unless they choose to be.
Alternatively, you can apply to a loan company such as Auto Credit Express ® that specializes in providing car loans to people with less-than-perfect credit.
Dealers can change your interest rate
One of the potential “hidden” fees when financing a car is a markup that dealers can add to your interest rate, even when you have a good credit score. This called “dealer reserve” in the industry.
Say the normal interest rate (“buy rate”) from the finance company used by the dealer is 4.0%. The dealer marks up the rate by a percentage, say 2.0%, making your real
rate 6.0%. This markup is never mentioned anywhere in the documents you sign. Car dealers claim the practice is justified to cover the cost of arranging customers’ financing. In fact, it’s additional profit and if you know it’s there, you can try to negotiate it out of the deal.
“ What you pay for your car loan or lease directly depends on your credit score ”
Automotive News reports that a number of manufacturers’ “captive” finance companies have settled on a 2.5% markup limit agreement. California now has a law that sets a 2.5% markup ceiling for most car loans. So it seems that 2.5% is now the magic number in the industry.
A common question from automotive consumers is, “Can I negotiate my loan interest rate?” In most cases you can try to negotiate the markup, but not the base rate, which is set by the finance company based on your credit score. In the past, there was no good way to know how much the car dealership was marking up the rate but, now, with the recent “agreements” and laws, we can assume the markup rate can to be as much as 2.5% added to the base rate.
Lease rates are particularly difficult, if not impossible, to negotiate because the rate is expressed as “money factor”, and the rate doesn’t appear in your lease contract.
Be aware that not all dealers mark up interest rates, but it seems to be a growing practice. Also remember that your base rate will be determined by how a finance company values your credit history and your credit score.
This is why is it so important to understand how credit scoring works. A low score or mistakes in your credit history report can easily force a high base rate, even without markup. Therefore, knowing your credit score and shopping around for the best rates are always good to do.
The deal is NOT done when you sign your car finance contract
Many customers mistakenly assume that when the dealer says he has done a credit check and lets the customer sign papers, that the deal is done and everything is legally wrapped up. Not true. The deal is not done until the loan or lease has been approved by a bank or finance company and the dealer has been paid for his car.
If a customer has credit problems, the original deal can change or be disapproved altogether. The dealer could ask that a new contract be signed, or that his car be returned.
What you sign and what it means
When a customer finances a car with a loan, he or she signs papers that essentially say the following: ” I agree to buy this car, using funds that will be loaned to me by a finance company or bank (if I am approved), and that the dealer will attempt to arrange this loan for me, and, if those funds are not approved by a finance company or bank, the deal is void unless the dealer can find another finance company that will approve me. If the loan approved, the finance company or bank will pay the dealer directly with those funds that have been loaned to me. The finance company or bank will then work directly with me to arrange monthly payments to repay that loan. I understand that the dealer will have then been paid in full for his car and will no longer be involved in the lease or loan.”
Leasing works the same way.
If your lease or loan is not approved
The finance company or bank can find problems in a customer’s credit history/score or debt-to-income data that makes them flag the application as high risk. They can then ask the dealer to inform the customer that the application was not approved, or that additional money is required, or that a co-signer is needed in order to re-submit the application for approval. Finance companies and banks work through the dealer; they do not work with the customer directly until the payment book arrives after approval.
Customers sometimes believe that they can keep a car if financing is not approved. Because they’ve signed a contract, they feel the car is theirs. This is a misconception and is not true.
With leases, if a customer is not approved, the finance company will often ask for a down payment when there was none initially, or may ask for a security deposit, possibly when there was none initially. This might allow the payment to remain the same even though the overall cost of the deal has gone up.
If the finance company or bank does not approve a customer’s lease or loan, the dealer is not paid, and the car still belongs to the dealer, even though he may have already allowed the customer to drive the car home a couple of weeks ago. If the dealer doesn’t get paid, he will want his car back, regardless of any contracts the customer may have signed.
What choices do you have?
First, automotive consumers should always know their credit history and credit scores. Get your FREE credit score and $1 credit report with a 7-day credit monitoring trial from TransUnion.
Second, the customer can ask the dealer if he works with other banks or finance companies who might be willing to approve the loan or lease.
Third, the customer can always shop for their own car financing at a bank or credit union and get pre-approved. Online loan companies such as Auto Credit Express ® provide car loans to people who have poor credit.
How does car financing work? We’ve explained all the things you need to know about auto financing and auto loans. Being knowledgeable will save you money and allow you to avoid costly mistakes.