Financing a Vehicle

1. Budgeting for Your Car

Buying a car is a major decision, often one of the biggest purchases you’ll make, so it’s easy to feel overwhelmed. We’ve already covered some important information you need to know, like figuring out how much car you can afford, whether to lease or buy, how to know the true cost of buying a car, and ways to negotiate.

Beyond choosing the right model, understanding financing options, setting a realistic budget, and knowing about postpurchase protections can make a huge difference. This lesson will help you navigate the financial side of buying a car so that you can drive away feeling confident and financially secure.

Before we do that, let’s have a quick refresher on how to budget for your car:

Step 1: Go back to the personal budget that you created. Begin by calculating your monthly income and subtracting essential expenses—like rent, utilities, groceries, and other bills. What’s left is what you could comfortably dedicate to car costs, which include more than just the monthly loan payment.

A common guideline is to keep all car-related expenses (loan payment, insurance, gas, and maintenance) within 10%–15% of your monthly income.

EXAMPLE

Let’s say you’re eyeing a car with a $400 monthly payment, which feels manageable. But after adding insurance, gas, and maintenance, your total car costs are closer to $600—almost double what you initially planned. By choosing a more affordable car with a $250 payment, you’d leave room in your budget for other essentials and avoid feeling financially strapped.

Step 2: You’ll also need to save for a down payment. A down payment is the up-front amount you pay when buying a car, which reduces the amount you need to finance it and lowers your monthly payments. Many experts recommend putting down at least 20% of the car’s purchase price, though any amount can help reduce your loan balance and interest costs.

EXAMPLE

Suppose you’re buying a $25,000 car. By putting down $5,000, you’re only financing $20,000 instead of the full amount. Over 5 years at a 5% interest rate, this down payment would save you around $1,500 in interest and lower your monthly payment. It’s one of the simplest ways to keep your total cost down and reduce the amount you’ll need to borrow.

Now that you have a feel for your budget and what you can afford, let’s look at some financing options you can consider.

1a. Financing Options

When buying a car, financing is a huge part of the decision. It’s tempting to go with whatever loan the dealership offers, especially when you’re excited to drive your new car home. But the lender and rate you choose can make a big difference in what you pay each month—and over the long run. By checking out a few options beyond the dealership, you can potentially save hundreds or even thousands of dollars.

As we’ve covered before, there are a few main choices you have: dealership financing, banks or credit unions, and online lenders. Each comes with its pros and cons, so let’s break them down to help you find the best fit. Let’s look closer at them each.

• Dealership Financing: Dealerships often have partnerships with multiple lenders, so they might offer a good rate, especially if they’re motivated to close the deal. However, dealership financing sometimes includes extra add-ons, like tire protection plans or paint sealants, that you may not need. Be sure to read the details so you know exactly what’s included, and remember the negotiation script you’ve already learned if you want to get any of those extra add-ons removed.
• Banks and Credit Unions: Banks are a familiar choice, while credit unions, which you already know from a previous lesson, are member owned and can sometimes offer even lower interest rates, especially if you have a strong credit history. Getting your financing at a credit union can help you save on interest charges over the life of the loan.
• Online Lenders: Online lenders are convenient and often offer quick approvals, with some specializing in auto loans. Sites like LendingTree let you compare rates from multiple lenders at once. Online lenders may offer lower rates due to their lower overhead costs, since they don’t have brick-and-mortar locations like a traditional bank, making them an appealing option.

EXAMPLE

Let’s say you’re buying a $20,000 car. You find three lenders offering 4.5%, 5%, and 6% interest rates for a 5-year loan. At 4.5%, you’d pay about $3,700 in interest over 5 years; at 6%, it’s $5,200—a difference of $1,500. Shopping around can save you significant money over time, so take your time and don’t settle for the first offer you get.

Alright! You’ve chosen which financing option you prefer. Now, let’s look deeper into how factors like interest rates, loan terms, and annual percentage rate (APR) impact your loan.

term to know

Dealership Financing

When the car dealership arranges a loan for you to buy the car.

1b. How Car Loans Work

Understanding how car loans work can help you avoid overspending. Car loans involve factors like interest rates, loan terms, and APR, all of which impact how much you’ll ultimately pay.

Remember what you’ve learned—the interest rate is the cost of borrowing money. A lower rate means smaller monthly payments and less interest over time, while a higher rate leads to larger payments and a higher total cost.

Fixed Versus Variable Interest Rates

• Fixed Interest Rate: The interest rate remains the same throughout the loan, so your monthly payments stay consistent. This predictability can make budgeting easier.
• Variable Interest Rate:

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Remember this rate? We introduced this in a previous lesson on personal lines of credit. The rate can fluctuate based on market conditions, meaning your payment could go up or down.

Let’s review: Variable rates fluctuate based on changes in the benchmark interest rate, which is typically set by central banks like the Federal Reserve in the United States. When the Federal Reserve adjusts the federal funds rate, this change impacts various loan and interest rates throughout the economy, including variable-rate loans. While variable rates sometimes start lower, they can increase, which may affect your ability to budget. Variable car loan rates are less common than fixed, but it’s still important to understand how they work.

EXAMPLE

Imagine you borrow $20,000 at a fixed 5% interest rate over 5 years. Your monthly payment would be about $377, and by the end, you’d have paid around $22,620 in total. If you take a loan at 8%, your payment would be about $406 per month, totaling $24,360—a difference of $1,740 over 5 years. This example shows how even a small difference in rates can add up significantly.

Loan Terms

Car loans usually range from 36 to 84 months, and the loan term you choose affects your monthly payment and total interest cost. While it might be tempting to choose a long-term loan with a smaller monthly payment, these loans come with higher overall interest costs. We’ve discussed the advantages of shorter-term loans that are 4 years or less, but let’s look at all your options:

• Short-term loans (36–48 months) have higher monthly payments but lower total interest costs, saving you money overall.
• Long-term loans (60-72+ months) offer lower monthly payments but higher total interest due to the extended repayment period. Long-term loans also carry the risk of “negative equity” or being “upside down” on the loan, where you owe more than the car is worth due to depreciation.

The annual percentage rate (APR) is like the all-in price tag for your loan. While the interest rate shows you what it costs to borrow the base amount, the APR goes a step further by including any extra fees the lender charges, like processing or administrative fees. This way, the APR gives you the full picture of what the loan will cost you over time—not just the monthly payments.

Pretend you’re comparing two loans, each with a 5% interest rate. Loan A has no extra fees, while Loan B has a $500 processing fee. Even though both loans have the same interest rate, Loan B’s APR will be higher because of the added fee. This means Loan B would actually cost you more overall, even though the interest rate looks identical. Be sure to ask the lender directly what the APR is and what extra fees are included so you have that information to make an educated decision when buying your car.

Once you’ve budgeted for your car and found the best loan option, you’re almost ready to hit the road! But there are still a few things to think about after the purchase to keep your car running smoothly and protect your investment. Understanding warranties, lemon laws, and routine maintenance will help you avoid unexpected costs and keep your new car in top shape.

terms to know

Fixed Interest Rate

A rate that stays the same throughout the loan term, keeping monthly payments consistent.

Variable Interest Rate

A rate that can change over time based on the economy, meaning your payments may go up or down.

Short-Term Loan

A loan with a shorter repayment period (typically 3–5 years).

Long-Term Loan

A loan with a longer repayment period (typically 5–7 years or more).

Annual Percentage Rate (APR)

The total yearly cost of the loan, including interest and fees.

2. After the Purchase

Once you’ve driven off the lot, the process doesn’t just end there. It’s important to understand the protections available to you in case something goes wrong with the car. Having a reliable vehicle is key, and warranties and lemon laws are there to help keep things smooth after your purchase.

Warranties

Most new cars come with a manufacturer’s warranty, which covers certain repairs for a set period, like 3 years or 36,000 miles. We covered this in a previous lesson, but let’s review it. The warranty is like a safety net for unexpected issues, as it can save you from paying out of pocket if something breaks down early on. Some warranties even cover things like roadside assistance or free oil changes, giving you extra perks during the first years of ownership.

For used cars, dealerships sometimes offer limited warranties or certified pre-owned (CPO) warranties if you’re buying a CPO vehicle. These can provide some added security, but the coverage might not be as extensive as a new car warranty.

Extended warranties are another option you might be offered, especially for used cars or once the original warranty expires. While they can add to the cost, they provide continued coverage for specific repairs, which might be worth it if you plan to keep the car for a while or if it’s a model known for higher maintenance costs. Just be sure to read what’s actually covered in an extended warranty, as they vary widely, and consider if it fits your budget and needs.

Lemon Laws

Most states have lemon laws that protect car buyers if they end up with a vehicle that has serious, repeated issues. If your new or, in some cases, used car has a defect that can’t be repaired after several attempts, it might qualify as a lemon. Lemon laws vary by state, but generally, if a car’s problem affects its safety, value, or usability and the dealer or manufacturer can’t fix it within a reasonable time frame, you may be entitled to a replacement, refund, or compensation.

hint

You can look at sites like Kelley Blue Book (www.kbb.com) for information on your state’s lemon laws. This will give you the information you need if you feel like your car has a defect that you want to bring to the dealer’s attention.

Routine Maintenance

Even with a warranty, routine maintenance is your responsibility, and it’s essential to budget for it. Oil changes, tire rotations, brake pad replacements, and other regular upkeep keep your car running smoothly and help it hold its value. Some people set aside a small amount each month as a car maintenance fund to cover these routine costs without dipping into other savings.

When the warranty runs out, being proactive with repairs and maintenance becomes even more important. Regular check-ups can help catch small issues before they turn into bigger, more expensive problems. Plus, keeping your car well maintained not only saves money but also helps if you plan to sell or trade it in the future.

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A good rule of thumb is to budget around $50 to $100 per month for routine car maintenance. This can vary depending on your car’s age, make, model, and your driving habits, but here’s a general breakdown to give you a sense of what to expect:

• Oil Changes: Typically, these should be done every 5,000–7,500 miles, costing around $30–$75 each time.
• Tire Rotations and Alignment: Tire rotation should be done every 5,000–7,500 miles and alignment annually or as needed, costing around $20–$100.
• Brake Pads and Rotors: Brake pads should be replaced about every 25,000–50,000 miles, with costs ranging from $100 to $300 for pads alone.
• Fluids: Changing other fluids (coolant, brake fluid, and transmission fluid) costs about $100+ each and may be needed every 30,000 miles or as specified by your car’s manual.
• Battery Replacement: This should be done every 3–5 years, costing between $75 and $200.
• Filters (Air, Cabin, and Fuel): These typically cost $10–$60 each and are replaced annually or as needed.

Over a year, routine maintenance can add up to about $600 to $1,200, which averages to around $50 to $100 per month. If you drive an older car or one with higher mileage, you may want to budget a little extra in case of unexpected repairs. For a newer or more reliable car, $50 per month might be enough.

Taking the time to understand your protections—like warranties and lemon laws—not only gives you peace of mind but also saves you from potential headaches down the road. Staying on top of routine maintenance means fewer surprises and a smoother ride, helping you keep your car running like new. With these steps in place, you can enjoy your car worry-free and focus on all the adventures that lie ahead.

terms to know

Manufacturer’s Warranty

Coverage from the car’s maker for repairs on new cars, usually for a set period or mileage.

Limited Warranty

Basic coverage for specific parts or repairs, often shorter and covering less than a full warranty.

Certified Pre-owned (CPO)

A used car that’s been inspected and comes with a limited warranty from the manufacturer.

Extended Warranty

Optional, additional coverage you can buy to cover repairs after the original warranty ends.

Lemon Laws

Laws that protect you if your new car has serious, unfixable issues, allowing you to seek a replacement or refund.