The vehicle transaction is the largest and most common consumer “impulse buy” in the world. An impulse purchase or impulse buying is an unplanned decision to buy a product or service, made just before a purchase. One who tends to make such purchases is referred to as an impulse purchaser or impulse buyer. Research findings suggest that emotions and feelings play a decisive role in purchasing, triggered by seeing the product or upon exposure to a well-crafted promotional message.
The Auto Loan
An auto loan is a type of secured loan that a person takes out in order to purchase a vehicle that they cannot pay for in full upfront. Auto loans are generally structured as installment loans and are secured by the collateral offered up in the form of the to-be-purchased vehicle. The aforementioned loan installments include a fixed portion of the loan amount as well as an interest rate that is predetermined, based on the buyer’s income and credit score. Auto loans can be financed directly through financial institutions or indirectly through dealerships. For those looking for considerably lower installments, leasing a car is a great alternative to financing a loan for purchase.
Direct Auto Loan vs. Indirect Auto Loan
There are two possible routes to be taken when you’re looking to finance a vehicle: a direct loan or an indirect loan. Direct auto loans are lent out from a bank, credit union, or local finance company. With this type of loan you work directly with a lender to secure a credit that would cover the amount of the car. The car serves as collateral and the lender would contractually own the car until the loan was paid back in full.
In a direct loan you agree to pay the amount financed, plus any accrued interest charges over a certain period of time. One advantage of this type of financing agreement is the ability to comparison shop, exploring differing lender options and credit terms before you even decide on a specific car. Another advantage to direct auto loans is receiving your credit terms in advance. In understanding your maximum loan amount, length of term, and annual percentage rate (APR) you’ll be able to use these details to improve negotiations with your dealer.
Indirect auto loans are often referred to as dealership financing, as it introduces a third party to the deal. This type of agreement allows the borrower to get an auto loan through the dealer that you’re purchasing the car from. This dealer becomes the middleman as they reach out to financial institutions on your behalf in order to find a loan that will cater to your personal budget.
An advantage to an indirect auto loan is the convenience of the process, the “one-stop-shop” appeal. The attraction to this type of loan is the ease and speed offered to a customer that is ready to make a purchase. Another appealing aspect of dealership financing is its competitive financing options as well as the varying types of special programs offered. Both of these benefits are exclusive to indirect loans, due to the relationships that a dealer might have with banks, financial institutions, manufacturers, etc. The drawback in this superficially flawless deal is that the interest rate for the borrower increases. This increase is a result of the design of an indirect loan, logistically favoring the dealership and ensuring that they make a hefty profit off of your loan.
Credit Score Affects Financing
The credit score is the single most important element of your automotive finance terms. A credit score is often described as your ability to pay back a loan; this ability is quantified and analyzed to determine your auto loan rate. Higher credit scores provide confidence to lenders that the borrower will pay back the loan in timely and consistent payments. This highly sought after clean credit report record is awarded with lower interest rates, which translates into lower monthly payments. Dealers will sometimes advertise “zero percent interest” in order to lure consumers, however this deal is typically only available to those with a premium credit score and/or graded as “Tier 1” credit, which is typically 720 or higher. The correlation between credit scores and auto loan rates are manifest via the seesaw effect, as credit scores rise interest rates fall and vice versa.
If you have bad credit (indicated by a credit score of 620 or lower) your interest rate increases and you run the risk of having to make a higher down payment upfront. Lenders will often extend the terms to make the transaction more affordable on a monthly basis. Such as 72-84-96 month payback terms. Dealers are also awarded with financial incentives for selling higher rates and longer terms.
It is critical to prepare your credit for transactions so you reduce the risk of poor finance terms. It might be advantageous for you to wait until you have saved enough money to cover 10-20 percent of the cost of the vehicle in order to avoid being in an upside-down position with your new asset. The term upside-down in this context refers to having negative equity on an auto loan, which occurs when the borrower owes more than the car is worth. A good way to avoid being in this precarious situation is to buy a used car rather than a brand new one. New cars depreciate in value by 20% as soon as they are driven off the lot. To put this into perspective, a brand new vehicle bought at $25,000 is only worth $20,000 immediately after purchase, when its “brand new” status advances to “previously owned.”
Subprime Auto Loan
For those with credit so poor that they are ineligible for standard auto loans, a solution may be found with subprime auto loans. These loans come with alarmingly high interest rates and in some cases prepayment penalties, which punish borrowers who attempt to pay off their loan early. Subprime borrowers often fall victim to predatory business practices by lenders, taking advantage of the desperation and ill circumstances of the borrower. Trends in data show that it very difficult for subprime borrowers to pay back high interest rate loans. Many individuals simply do not have a choice when signing off on poor loan terms, as they need transportation for work and other life activities.
Auto Lease vs. Auto Loan
Leasing a vehicle is similar to purchasing, however there are some key differences; when you buy a vehicle, the loan value is based on the entire cost of the car and when lease a vehicle you’re only responsible for financing the depreciation that occurs during the term of the lease. A lease generally lasts 2 to three years and at the conclusion of the lease term, the vehicle is returned to the dealership. Leases are significantly cheaper in the short term, often 25-50% lower than your monthly payments would be if purchasing the same vehicle. Every situation is different and it is important to understand all aspects of your situation and lease – purchase options.
The main advantages of leasing a car is the warranty that comes with it, providing comprehensive coverage, and the excitement of driving a new car every few years. The biggest disadvantages are the many stipulations in order to be eligible for a lease and the various requirements once you obtain the lease. These conditions include penalty fees if you are driving too many miles or failing to complete consistent maintenance checks.
The pros of purchasing a car are the buildup in trade-in or resale value and having the ownership and freedom to do what you’d like with your car. The cons include the responsibility of selling or trading your car, and the repair costs that your warranty may not cover. Whatever course you choose in attaining a new vehicle, be sure that your options are appropriately researched so that you are qualified to make the best possible decision for your particular circumstances. Start by confronting your credit, looking at improvement potential and preparing your credit for your next automotive transaction.