Cheap Car Financing

The best way to finance a car might be to skip the dealer. Here are some alternatives.

Ever wonder how auto dealerships make money these days? Thanks to the information superhighway (sorry, we couldn't resist), it's getting harder for salespeople to squeeze customers on price. That leaves them with the opaque world of financing to pad their profits.

Nowadays, a dealership's best salesperson is typically the finance and insurance manager. Customers who don't know how to play hardball might get an extra 2% to 3% added to the wholesale interest rate, says Chris Larsen, chief executive officer for E-Loan, an online lender that competes with dealers for auto loan business. "Many people don't realize that after they set the price (of the car) and go into the (finance manager's office), that's when the most profitable part of the negotiating is done," he says.

This is especially true for American automakers, which for years have struggled to compete with foreign producers on price and quality. Consider the latest results posted by General Motors (GM) and Ford Motor (F). More than three-fourths of GM's 2004 profit came from its lending operations, while Ford reaped 85% of its earnings from finance operations. Ford's credit unit earned a record profit of $2.9 billion last year, up from $1.8 billion in 2003. Those profits offset the losses it incurred producing the cars themselves.

Finance managers try their best not to let customers drive away with a bargain. That's why auto experts recommend consumers line up independent financing before they step foot into the showroom.

That's just what 41-year-old Michael Gopen of Gorham, New York, did. Last October, Gopen decided to buy a used 2000 Ford Explorer. Wanting to avoid bait-and-switch shenanigans at the dealership, he filled out auto loan applications beforehand at his local credit union and online. One lender made him a deal he couldn't pass up: an interest rate of just 4.99%. (The average rate for four-year used cars is 7.82%, according to Informa Research Services.) Within 24 hours, Gopen had a blank check in his hand. Now that he was essentially a cash buyer, all he had to do was focus on negotiating a price for the 4-wheel drive SUV that had caught his eye.

Here are five tips on how to negotiate the best interest rate on an auto loan.

1. Shop Around
"The biggest mistake consumers make is that they neglect to shop for their financing in the same way they shop for their vehicle purchase," says Mark McCready, director of pricing strategy for CarsDirect.com, a Los Angeles-based auto Web site. After all, what's the point of saving a couple of thousand dollars off the sticker price if you make up for it in higher interest payments?

Shopping around for a great interest rate is easier than you might think. After you decide on the type of car you wish to purchase, fill out a quick application at your local bank or credit union, and do the same at online lenders, such as LendingTree.com or E-Loan. Within minutes, you'll be able to compare all of your offers and decide which one works best for you. Once you've chosen a lender, you'll be asked for some tax forms and a pay stub. In return, you'll get a blank check (or something comparable) that you can take with you to the dealership.

2. The Car You Choose Matters
More than just your credit score determines your interest rate. The car itself also plays a part. To get the absolute best deal, try to select a vehicle that holds its value. If a car has a low residual value, it's considered a higher risk for the lender and will cost you a bit more, says Ed Powell, chief consumer officer for LendingTree.com. You can research residual values on Web sites such as Kelley Blue Book and Edmunds.com.

Lenders also prefer that new car smell, and give their best rates to people financing the latest models. If you purchase a used car, expect a higher rate — at least one percentage point. Why? A lender doesn't know the condition of a used vehicle, and therefore assumes a slightly higher risk, says E-Loan's Larsen.

3. Shorten the Term and Put a Chunk of Money Down
Try to keep the term of the loan as short as possible. The most competitive rates are for loans of 36 months or less. As soon as you cross over into the 37-month range, the interest rate can climb 3/4 of a point, says Larsen. A 61- to 72-month loan is typically 1.5% higher than the shortest loan.

It's also a good idea to make a sizable down payment. Lenders look at what's called the loan-to-value ratio. Ideally, they like to see 10% down on new cars and 20% on used vehicles, says Greg McBride, a senior financial analyst at Bankrate.com, a north palm Beach, Fla.-based financial information Web site. This helps protect them from depreciation as soon as you drive off the lot. And if you're willing to make automatic payments from your checking or savings account, as Gopen did, you can also get a slightly sweeter deal.

Auto Loan Rates
Type of Vehicle 36 Months or Less 37-60 Months 61-72 Months
New Vehicle 4.05% 4.79% 5.49%
Used Vehicle (Dealer) 4.69% 5.19% 6.05%
Used Vehicle (Non-Dealer) 6.35% 6.55% 7.35%
Refinance 5.39% 5.89% 6.69%
Data as of Jan. 20, 2005
Source: E-Loan

4. Don't Leave Money on the Table
It never hurts to see if the dealer can beat the interest rate you secured on your own. Sometimes manufacturers need to unload certain models, and will offer promotional financing or a cash rebate — something you might not want to miss out on.

The most obvious example here is zero-percent financing, a craze that swept the auto industry a few years ago. Note, however, that fewer dealers are offering this incentive these days — and even if you can find one, it might not be right for you, warns Ken Potter, vice president of sales for CarsDirect.com. Sometimes it makes more sense to take a cash rebate — particularly if you plan to sell you car after just a few years.

Here's why. Let's say you're planning to purchase a car that costs $30,000. You might be presented with two choices: zero-percent financing over a term of, say, five years, or a $5,000 rebate, which means you would have to borrow only $25,000. It's important to note that when a manufacturer offers a rebate, the vehicle loses its resale value, or residual value, faster. So if you take a zero-percent loan on a $30,000 car and try to sell it before the loan is paid in full, you might find that the car isn't worth as much as you hoped, says Potter. In fact, you could get stuck writing a check to cover the difference. So if you can get attractive financing independently, it might make more sense to put the rebate toward the down payment and borrow less money.

To help you crunch the numbers, use our Cash Back or Low APR calculator.

5. Refinance
It's never too late to shop around for financing. If you think you got a bad deal at the dealership, you could always refinance the loan somewhere else. And unlike a mortgage, there are virtually no costs to be paid — just a $15 title fee in many cases.