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Car Financing - Dealer Auto Financing :
How it Really Works

What it means to get approved for and agree to a car loan

 

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 say it again 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 what you pay for financing.

Dealers always sell for 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 finance company. The bank charges dealers interest on these loans. Dealers have to sell cars to pay off these loans with associated 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 dealers give cash customers a larger price discount. 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.

Dealers don't finance car loans and leases
Dealers are not bankers. They do not directly finance cars they sell or lease. Instead, they have a preferred list of finance companies or banks that they work with to provide customers with financing. Most dealers use the car manufacturer's "captive" finance company, such as Ford Credit, and Honda Finance. Dealers help arrange financing on customers' behalf — as a service.

Customers do not have to accept dealer-arranged financing. They can find their own financing with banks or credit unions if they choose.

Key point: Dealers do not finance car leases and loans. Dealers do not approve customers for leases or loans -- they "screen" customers' credit scores, but do not approve. 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. Once financing has been arranged, the dealer is out of the picture.

Dealers pre-approve car financing
A dealer may do a cursory preliminary check of a customer's credit history 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.

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 score, 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. This means your FICO score is higher than about 700. You qualify for the best interest rate.

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 find one, your interest rate will likely be extremely high.

Get all three of your credit reports and credit scores at FreeCreditScore.com.

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.

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 from the finance company used by the dealer is 6.0%. The dealer marks up the rate by a percentage, say 2.0%, making your real rate 8.0%. 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.

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 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 FICO 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 is going to be as much as 2.5% added to the base rate.

Lease rates are particularly difficult to negotiate because the interest rate is expressed as "money factor" (see the discussion of lease finance fees in our Monthly Lease Payments article), 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. Get all 3 of your credit reports plus 3 free scores here.

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.

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 the 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.

With leases, a finance company will sometimes ask for a down payment when there was none initially, or may ask for a larger security deposit, possibly when there was none initially. Often, this will 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. See our article, Dealer Wants Car Back, for more details.

What choices do you have?
First, the customer should always know their own credit history and FICO score from an online source such as FreeCreditScore.com before ever setting foot in a dealer's showroom. This way, there won't be any surprises later. 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 and get pre-approved.

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