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Understanding The Terminology Used In Car Financing

13 August 2014

Mathéo Gerard

The process of buying a car should be exciting, but it can turn out to be a frustration if you are financing a vehicle. Much of the problem is that prospective car buyers don't understand the financing process, and that lack of knowledge can cost them more money than necessary. Fortunately, much of the confusion can be cleared up by simply understanding some of the terminology and lingo used in financing. Here is a down-to-earth explanation of car financing terminology, so you will be prepared and confident when you start looking for a new (or new-to-you) car:

Interest rate

This is the cost of borrowing money expressed as a percentage. Most auto loans are calculated using simple interest; the amount financed is multiplied by the interest rate to calculate the interest charge. That charge is then added to the amount financed, and that equals the total loan amount.

Be sure to understand that interest rates are not always set in stone. Your quoted rate may not be solely based upon your credit worthiness, though that is obviously important. Some lenders will occasionally mark-up the rate to build-in additional profit for themselves; while this is not illegal or unethical, it helps to know that negotiating on the rate might be possible and save you money in the end.

APR

The Annual Percentage Rate (APR) is a figure that includes loan expenses other than the actual amount of the loan. This takes into consideration lender fees, application fees and points; if there are no additional expenses related to the loan, then the APR should equal the interest rate. Be sure to pay careful attention to this number because it reveals the true cost of a loan by including a lot of "hidden" charges that don't show in the interest rate alone.

Points

Officially known as "discount points", this refers to a buy-down of a loan interest rate. A borrower can purchase points on a loan in order to lower the interest rate; sometimes the dealer will purchase points during negotiations to help the buyer move forward on a car deal. The cost of buying down an interest rate is included in the APR calculation.

It is easy to confuse points with a down payment since both involve up-front money; the difference is that down payments lower the cost of the car, while points lower the interest rate. Be sure to explore your options when negotiating a car loan, and ask the dealer to provide you with cost scenarios so that you can make an informed decision about purchasing points.

Term

This is the period of time, usually expressed in months, for which the loan will run. There are several options for terms such as 36, 48, 60, 72 and 84 months, but the longer terms come at a price in the form of higher interest rates; therefore, the overall cost of your vehicle will be more. For example, compared to a car with $20,000 financing over a period of 60 months at 4% interest, you will pay over one thousand dollars more for the same vehicle financed for 72 months at 5% interest.

Credit score

A credit score is a single-number summary of your estimated credit worthiness, usually expressed as a number between 300 and 850. Much of the confusion around credit scores lies around the fact that there is no one, "authoritative" number for any person's situation. There are three credit bureaus in the United States--Experian, TransUnion, and Equifax--responsible for maintaining master credit files for individuals, and each one of these computes their own credit score. The exact calculations used by each are closely-guarded secrets and that leads to multiple scores for individuals. In addition, other entities such as banks and lenders have their own "in-house" credit scoring and can arrive at completely different numbers, too.

That said, the bottom-line for you as a would-be car buyer is to have as high a credit score as possible regardless of how it is calculated. While the formula isn't known for any of the three bureaus, it is still clear what factors profoundly influence credit scores:

• Past payment history such as timeliness and defaulting on debt
• Amount of current debt
• Number of open credit accounts
• Number of bankruptcies
• Number of inquiries into your credit

Before you go searching for a car or financing, go to websites and obtain copies of your credit reports and scores from the three bureaus. Federal law entitles you to annual free reports from each bureau, but you will probably have to pay additional fees to obtain your scores. It is worth having these scores, though; when you apply for financing, you can utilize the information to help you negotiate a favorable deal.

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