1. Buying a New Car: Introduction
  2. Buying a New Car: Signs It's Time to Buy
  3. Buying a New Car: Getting Started
  4. Buying a New Car: The 5 Best Safety Options
  5. Buying a New Car: Smart Strategies at the Dealership
  6. Buying a New Car: 5 Common Mistakes
  7. Buying a New Car: Sneaky Tricks Car Salespeople Pull
  8. Buying a New Car: Financing Your Purchase
  9. Buying a New Car: How to Spot a Great Car Deal
  10. Buying a New Car: Websites, Tools and Apps to Use
  11. Buying a New Car: How to Maintain a Car's Value
  12. Buying a New Car: Top 10 Takeaways

Unless you love numbers, financing is the least fun part of the car-buying process. In addition to understanding how much vehicle you can afford and whether you should finance of lease a car, truck, SUV or minivan, there are many complicated terms involved in vehicle financing that can make a big difference in what you ultimately pay.

Understanding how car financing and leasing works – and the terminology involved – is key to getting advantageous terms on the purchase of a new vehicle. Here is some information to help orient you. 

Finance or Lease?

If you can't pay cash, the first big decision you have to make is whether to finance or lease your vehicle. It's been the subject of debate ever since these options appeared. And, to be fair, there are pros and cons for each.

Financing involves you paying back the cost of the vehicle on a set payment schedule and at a set interest rate. You usually will make monthly payments over an extended period of say 60 months (five years) and for a fixed interest rate of say 5%. The upside is that you will own the vehicle outright once it is paid off and that you will not be limited to driving a set amount of miles per year as with a lease. But for this to be an attractive financing option, the interest rate charged needs to be low – 3% or lower is recommended (a 0% interest rate is ideal). Also, the length of the loan needs to be negotiated and kept low. Financing is available through the dealership, as well as through bank loans and other methods (see below). Your credit rating will likely affect the interest that you are charged.

With a lease, you essentially rent the car from the dealership for a set period of time. You make monthly payments to lease the car for 36 or 48 months, for example. These payments are typically lower than if you were to buy a car outright. When the lease period ends, you return the car to the dealership and get another car or simply walk away. Leases are great for people who want low monthly payments, and who like to drive new cars with the latest technology all the time. But leases come with a lot of restrictions and penalties. Most leases prevent people from driving more than 12,500 miles a year. Put more miles on the vehicle and you end up paying penalty fees. You also can’t modify a vehicle you lease or damage it in any way. You will be charged for every nick and scratch. But the big downside to leasing a car is that you have nothing of value when the lease ends. You are not left with a car that you could drive fora  few more years or sell. With a lease, the payments never end.

Other Financing Options

While dealer financing and leases are the most common means of paying for a new car, they are by no means the only method available. There are many other ways to finance a vehicle, ranging from the conventional to the unconventional. These options and their benefits and drawbacks include:

  • Cash from savings. Paying cash means that you will not have to take out a loan, your debt load will not increase and you will not be charged interest or have monthly car payments. In the long run, you will save a lot of money in interest payments. This only makes sense if you can draw the money from a source that won't endanger your future, such as a bank account or money market fund. A not-good source of cash would be your retirement fund – even a Roth IRA where withdrawing contributions (not earnings) will let you avoid the potential tax hit and penalties of taking money from a Traditional IRA or 401(k) if you're younger than 59½. You'll also lose the future tax-advantaged investment growth from that fund and undermine your retirement.
  • Bank loan. Most banks offer specific loans for the purchase of a vehicle. Banks often provide comparable (or lower) interest rates to a car dealership. Taking out a loan from a bank and paying it off on time can boost your credit score. Plus, banks are often flexible with their repayment periods.  But if you fall behind on your payments, the bank could increase the interest rate on the loan. Not all banks offer low interest rates so compare the rates to other banks and to what your dealership offers. Also watch for prepayment penalties, in case you want to pay off the loan sooner or refinance it.
  • Home equity line of credit. Home Equity Lines of Credit (HELOCs) are secured against the house you own. The minimum monthly payments are usually lower than those required when financing through a car dealership or a bank, as are the interest rates. Interest payments are generally tax deductible, just as on a primary mortgage. However, if you use a HELOC, it means the car purchase is secured against your house and the bank could seize your home and sell it to pay off the line of credit.
  • Private lenders. Individuals will personally lend you money to buy a vehicle. This usually requires that you sign a contract agreeing to repay the loan by a certain date and at a specific interest rate. This can be a reasonable option for people who have bad credit and do not qualify for more traditional financing options through a car dealership or bank. But when you take out a loan from a private citizen you have none of the protections and guarantees you get from a bank or credit card company. If you don’t make the payments, or if the relationship sours between you and the lender, things could get ugly.

Hidden Costs and Extra Fees

There is seemingly no end to the hidden fees and extra costs that inflate the purchase price of a new car. Salespeople at dealerships count on the fact that consumers do not know what these hidden costs and extra fees mean, and therefore pay them without asking questions.

You should ask the questions and see if any of these fees can be waived. Here's what to watch for: 

  • Admin fees. Some dealers call this a “processing fee” or “documentation fee,” but it is all the same thing – it’s the cost to cover processing the paperwork on the sale of the car you bought.
  • Termination fees. The fee charged in the event that you want to break a lease agreement or cannot continue making monthly car payments. The termination fee is typically for the full value of the lease or repayment plan, plus a hefty penalty   .
  • Freight. This is the cost the car dealership pays to ship the car you bought from the plant where it was manufactured to the dealership where it is sold.
  • Extended warranties. This is typically a service contract that extends a regular warranty. Research from Consumer Reports found that 55% of owners who purchased one "hadn't used it for repairs during the lifetime of the policy, even though the average price paid for the coverage was just over $1,200." Those who did spent on average "hundreds more" for the coverage than they saved in what repairs cost them.
  • A.D.M. Stands for “Additional Dealer Mark-Up.” Sometimes expressed as “A.D.P.” which is “Additional Dealer Price.” This acronym enables the dealership to charge more than the advertised sticker price on a car.
  • Rebates. An incentive that may not actually produce a reward for the customer. Rebates are used to get people in the door to buy a car. Once a vehicle is purchased, buyers may find that they have to jump through a series of hoops to get the promised rebate, or discover that there is a loophole preventing them from actually getting it.

GAP Insurance

Guaranteed Auto Protection (GAP) insurance covers the difference between the value of a vehicle and the balance that is still owed on a car loan or lease. For example, say you owe $15,000 on a car and it is stolen or totaled. If you don't have “new-car replacement coverage” and your insurance company determines that the vehicle's market value was only $10,000, the Gap insurance would cover the $5,000 difference so you can repay your loan. 

 Some car owners have the misfortune of still having to make car payments on a vehicle they no longer have because their auto insurer won’t cover the loss. And it is common for car owners to be upside down in their vehicles (owing more than the car or truck is worth) given the high cost to purchase a new car and the depreciation that occurs.

More broadly, GAP insurance ensures that the company financing your car gets its money no matter what happens. For this reason, some financing companies and lease contracts require that you take GAP insurance, which can cost more than $500. Whether you should take GAP insurance depends on factors ranging from the length of your repayment plan to the amount of your down payment on a new car and the terms of your automotive insurance. If you plan to pay your vehicle off in 48 months or less, and if your insurance includes new-car replacement coverage, then you shouldn’t need to add GAP insurance. Be sure to understand your current auto insurance policy.    

Repayment Period

Next to the interest rate, the most important point to negotiate when buying a vehicle is the repayment period. The consensus of financial experts is that a shorter repayment plan is best – especially as every vehicle depreciates in value over time. Some financial advisors, such as Clark Howard, recommend paying off a new car in 24 or 36 months. This way, you will get several years of payment-free driving out of the vehicle before it begins to break down and cost you money in repair costs.

Due to the high cost of many new cars, dealerships are offering repayment periods as long as 72 and even 84 months. Consumers are often enticed by longer repayment periods because it results in lower monthly payments. Do the math on the interest you are paying over a longer period of time, and you'll find it is rarely worth stretching out the time you take to pay off a new car. People who take long repayment periods can also end up with negative equity on their vehicle.

The Bottom Line

Financing is the most complicated and critically important aspect of a new car purchase. Understanding the financing options available to you, as well as the hidden costs and fees and the tricks salespeople use, will help to get you favorable terms on your next vehicle purchase.

Negotiating a low interest rate and short repayment plan should be your main priority when setting up the payment of a car. Check out Edmunds website for a comprehensive glossary of automotive terms and definitions. 

Buying a New Car: How to Spot a Great Car Deal
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