Sept. 16, 2010

FORT LEONARD WOOD, Mo. -- Before I go to the dealership to buy a car, do I need to know my cost of financing by shopping around for interest rates'

Yes, to protect yourself and to find the best offer on financing, you should compare different rates.

This article is designed to help you understand how car dealers profit and thus better prepare you to avoid common pitfalls when purchasing a car from an auto dealer.

How dealerships profit

Car dealerships profit from three transactions: selling you the car, service on the car, and financing the purchase of the car. Dealers profit on the difference between the price they pay for a car and the price they sell you the car, but this is not where the real profits are made. Dealers earn a substantial profit on the money they lend you to enable you to purchase the car. Dealers attempt to lend you money at a high interest rate. After you sign the car contract, they sell your financing to a financial institution who gives them a lower interest rate based on your credit score. The difference between the high interest rate the car dealer offers you and the low interest rate the car dealer sells your contract for gives the car dealer a profit.

What does it mean when your dealer is saying that he or she will finance you at a 15.9 Annual Percentage Rate' Does this mean that I will pay 15.9 percent interest on the $16,000 car that I am about to purchase' Unfortunately, the answer is a resounding "no!" That would be an example of simple interest, which is not the type of interest that you will encounter when you finance the purchase of a used car. APR is a measure of the cost of credit expressed as a yearly rate. The APR includes the quoted interest rate, plus certain service charges and other finance charges associated with a loan. This rate is assessed on the balance of the loan outstanding each year. This is an important point because a $16,000 car loan with a simple interest rate of 15.9 percent will cost drastically less than the same $16,000 loan with an APR of 15.9%. $16,000 with a simple interest rate of 15.9 percent will cost the buyer a total of $18,544 over the life of the loan, while that same loan with an APR rate would cost the buyer $23,294 over the life of a 5-year loan. This simple difference in terminology represents a difference of $4,750.

Here are two common pitfalls consumers should avoid when making a car purchase.

Common pitfall #1:

Consumers do not shop for the best auto loan interest rates

Do you know the interest rate a bank will charge you for borrowing a particular amount of money' Interest is the amount of cash you pay to borrow money. Many consumers do not investigate how much money they can borrow and at what interest rate. Before you enter the dealership, find out the interest rate other banks will charge you to borrow the anticipated purchase price of the car. Since, you will be financing your car, consider sources other than the dealer to finance your purchase, such as a bank, credit union or financing company. Before contacting any financial institute, have an estimate of how much you will need to borrow to purchase the car. While car values vary, you can gain a reasonable estimate by finding out the cost of similar year, make and model vehicles in your market.

After you tell the financial institution the amount you want to borrow, the financial institution will give you Truth-In-Lending Act disclosures. TILA disclosures provide the annual percentage rate (the cost of your credit as a yearly rate), the finance charge (dollar amount the credit will cost you), the amount financed (the amount of credit provided to you), the total of payments (the total amount paid after all payments), and total sale price (the total cost of your purchase on credit, including your down payment). The financial institution will also tell you the length of the loan. Combined, these indicate your creditworthiness.

It is better to have this information from two different financial institutions, so you can compare these offers against the dealership's offer. When the dealership offers you financing, the dealership is required to give you the same TILA disclosures as the financial institutions and allow you to leave the dealership with those disclosures on paper and in your hand. While these disclosures are often found in the contract of sale, that is not a reason to prevent you from leaving with the disclosures.

How do you know which financing offer is best' Because you have multiple financing offers from other banks, you can compare them to the dealer's financing offer. The "total of payments" from the TILA disclosures is a good indication of the best loan. However, you should also compare the length of time for repayment to determine the overall best loan.

Common pitfall #2:

Consumers negotiate monthly payments, not price

Understand the total cost. A monthly payment of $100 over six months totals $600. A monthly payment of $90 over seven months totals $630. While this math seems simple, many consumers do not take time to evaluate the total cost. As illustrated above, the lower monthly ($90 vs. $100) payment results in you paying more money ($630 vs. $600). If you understand this concept, you can make the right choice for your financing.

Dealerships often try to negotiate the monthly payment and not the total purchase price of the car. It is recommended you always negotiate the total purchase price of the car and not the monthly payment.

(Editor's note: Luyties is an attorney with the Fort Leonard Wood Legal Assistance office.)