When low advertised interest rates yield a higher cost
of borrowing than traditional bank rates.
How dealer financing works for new cars.
In most cases dealers use their manufacturer's financial
institutions to finance new cars. General Motors has set up
GMAC and Chrysler has formed Chrysler Credit, for example.
These institutions are responsible for generating all the
low interest ads you see on television or in the newspaper.
You have probably seen these ads; they usually state interest
rates such as 0 percent or 0.9 percent for 48 months on select
vehicles, and then have a lot of small print you cannot read
at the end of the ad. If you can read the small print, you
usually see a low rate advertised or cash back. For example,
you will see 0.0% or $1500 cash back on all select models.
This means that you have two choices. You can opt to go with
the low interest rate, or you will get a discount or cash
back of $1500 if you finance yourself or pay cash. In any
case, you do not get both! This section covers this type of
financing and reveals the pros and cons of using manufacturer
financing.
When to use manufacturer-financing rates and when to use
your bank.
Let's assume that you are buying a car that offers 2.8 percent
financing or $2,000 cash back. The vehicle price is $20,000
and in this example there is NO tax.
Because there is $2,000 cash back, you will have to add that
to the total loan. For example:
$20,000 + $2,000 = $22,000
$22,000 financed for 48 months at 2.8 percent gives you a
payment of $485.01 per month.
If you went to your bank and financed the car, you would
save the $2,000 on the selling price but your interest rate
is high - let's assume 7 percent. In this case, you would
have:
$20,000 financed for 48 months at 7 percent gives you a payment
of $478.92. Notice it is only a $6.97 per month difference!
(7 percent is cheaper!)
How can a 2.8 percent interest loan and a 7.0 percent interest
loan be only $6.97 per month difference in payment? AND
why does 7 percent offer a cheaper loan payment?
Let's look at the cost of borrowing to determine what is
happening.
On the 7.0 percent loan and the amount financed was $20,000
and the total interest you would pay over 48 months is: $2,988.16.
On the 2.8 percent loan the interest, you would pay is $1,280.48.
However, you would pay $2,000 more for the car. Your real
cost of borrowing is then $3,280.48. (That's $2,000 + $1,280.48=
$3,280.48)
The real difference is $3,280.48 (The 2.8% cost of borrowing)
- $2,988.16 (the 7% cost of borrowing) = $292.32. That is
it! 2.8 percent has a cost of borrowing of $292.32 higher
than the 7 percent loan!
So how do you combat this situation to get the best loan?
You have to determine the break-even rate of the loan and
shop that amount. The break-even rate is the normal interest
rate that matches your payment on the low financing. For example,
the following two loans have completely different interest
rates yet their payment is the same.
Loan One: 2.8% Financing
$2,0000 - car price plus
$,2000 Rebate (Total loan amount = $22,000)
48-month term
$485.01 per month payment
Loan two: 7.65% Financing
$20,000 - car price
48-month term
$485.01 per month payment
Notice that the payment of $485.01 per month is the same
at 2.8% and 7.65% (Because of the $,2000 increase in the price
of car at 2.8%, the cost of borrowing and the payment are
the same.)
Your break-even Interest rate is 7.65% - the interest rate
that provides the same payment as the low interest manufacturer's
loan. By knowing the true cost of borrowing, you can determine
if your bank or any other lending institution can give you
better terms. For example, if your bank is willing to give
you a lower rate than 7.65%, then your payment for the car
will go down and you will save money. If they offer you 7.3%,
you will get better terms and savings than the manufacturer's
2.8%.
An easy way to determine your break-even rate of interest:
Step one is to determine the exact payment of a car loan
at the manufacturer's low interest special. To do this, you
need to get the exact price on the road with all your taxes
minus any down payment. Take the lump sum of the loan and
figure out the payment at the special interest rate using
an advanced loan calculator. This gives you payment one. (You
can use an advanced loan calculator online by entering
here.)
Next, you need to determine the price on the road of a vehicle
that has no rebates or add-ons to the price (in other words,
a cash price). With this amount, you need to work backwards
to figure out what interest rate would give you the same payment
as the low interest rate payment the dealer is using. You
need to roll back your payment in the calculator to interest.
For example, the payment in the example above is $$485.01
per month at 2.8%. To figure out the interest rate that would
give you the same payment on the cash price, you would enter
the on the road cash price into the calculator and the payment
of $485.01 and ask it to roll back by interest (to calculate
the interest). The interest you would get is 7.65%. - the
break-even interest. Now contact your bank or lending institution
and see if they will beat that 7.65% rate. If they do, you
will save money! (Note that the low rates used by the dealers
are fixed rates that do not fluctuate with interest rates.
Make sure you are getting a quote on a fixed rate of interest
and not a variable rate that floats up and down as interest
rates change. You have to compare apples to apples.)
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