Car Deal Canada

How Car Financing Works

How Car Financing Works

Buying a new or used car is an exciting experience, but it can also be stressful trying to figure out how to pay for it. While some people can pay cash upfront, most buyers will need to finance the purchase through an auto loan. This allows you to pay for the vehicle over time through a lender like a bank, credit union, or dealership.


Financing spreads out the cost of your car into more manageable monthly payments. It also builds your credit history when you make those payments on time. However, you’ll end up paying more overall with interest charges. Carefully considering the pros and cons of financing is important.


This guide will explain the key steps involved when you finance a car purchase. Understanding the process ahead of time will give you confidence when it’s time to get a loan and buy your new ride!

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Checking Your Credit Score

One of the first steps when financing a car is to check your credit score. Your credit score is a number that lenders use to determine your creditworthiness and the interest rate they will offer you. Knowing your score ahead of time allows you to understand your chances of getting approved for an auto loan and the terms you may qualify for.

There are a few ways to check your credit score for free. Many banks allow customers to check their score through online banking. You can also use credit monitoring services like Credit Karma and Borrowell which provide free access to your score. It’s a good idea to check your score through both Equifax and TransUnion, the two main credit bureaus in Canada.

When you receive your credit score, the number itself gives you insight into your credit health. Scores range from 300 to 900, with higher scores indicating better credit. A score above 680 is considered good credit and will qualify you for the best loan rates. A score under 600 is poor credit and will make getting approved more challenging.

Checking your credit score isn’t just about the number. Reviewing your full credit report allows you to check for any errors and see the details impacting your score. This includes your payment history, credit utilization, credit history length, and other factors. Knowing what’s in your report puts you in a stronger position when applying for financing.

Getting a sense of where your credit score stands before going through the financing process is crucial. It allows you to take steps to improve your score, dispute any errors, or adjust expectations if your credit needs work. Understanding your credit health early gives you more control over the auto loan offers you eventually receive.

 

Research Loan Rates/Terms

When shopping for an auto loan, it’s important to research current interest rates and loan terms being offered. This allows you to see what average rates are right now and find the best financing option for your situation.

As of January 2023, the average interest rate for a new car loan was around 5.2% for a 5-year loan term and 4.5% for a 4-year term. For used cars, average rates were a bit higher at around 6% for a 5-year loan. Rates can vary significantly though based on your credit score and history.

In addition to interest rates, loan terms are an important factor to consider. Common auto loan terms are 24, 36, 48, 60, and 72 months long. Shorter terms often have lower rates but require higher monthly payments. Longer terms have more affordable payments but pay more total interest over the life of the loan.

Experts recommend not taking a loan longer than 60 months to avoid being underwater on your loan. Carefully weigh the tradeoffs of different loan lengths to choose one that fits your budget while minimizing interest costs.

 

Get Pre-Approved for an Auto Loan

Getting pre-approved for an auto loan before visiting dealerships can make the financing process much smoother. Here are the key benefits of securing pre-approval:

 

  • Know your budget – Pre-approval lets you know the maximum loan amount and monthly payment you qualify for based on your credit, income, and expenses.
  • Strengthen negotiating position – Showing a pre-approval letter indicates you are a serious buyer and can give you more leverage when negotiating the vehicle price.
  • Compare loan offers – You can apply with multiple lenders and compare the loan terms side-by-side.
  • Save time – The financing process at the dealership will be faster since the loan application is already completed.

 

The best places to apply for pre-approval are banks, credit unions, and online lenders. You’ll need to provide information like:

 

  • Personal details – Name, address, Social Security Number, date of birth
  • Income verification – Pay stubs, tax returns, W-2s
  • Down payment amount
  • Vehicle information – Make, model, year, mileage, value

 

The lender will perform a hard credit check and review your credit history, income, existing debts, and down payment amount. This allows them to offer pre-approval along with estimated loan terms if you qualify. Having a pre-approval letter in hand before visiting dealerships can give you confidence and negotiating power during the financing process.

 

Comparing Loan Offers

Once you have been pre-approved for financing, it’s time to start comparing actual loan offers. This is one of the most important steps in getting the best auto loan for your needs and budget.

The first thing to look at is the Annual Percentage Rate (APR). This takes into account the interest rate as well as any fees associated with the loan. A lower APR is always better, but be sure to compare offers carefully, as terms and fees can vary.

You’ll also want to pay close attention to the loan term, which is how long you have to pay back the loan. Longer terms of 5-6 years mean lower monthly payments but greater interest costs over time. Shorter terms often have higher monthly payments but you pay off the loan faster.

Evaluate any fees that come with the loan as well. Origination fees, documentation fees, and prepayment penalties can all add to the total cost. Read the fine print to avoid any surprises.

Choosing a fixed interest rate rather than a variable rate will ensure your monthly payments remain the same over the life of the loan. This makes budgeting easier.

Carefully going over these key factors – APR, loan term, fees, and interest rate type – for each loan offer you receive will help guarantee you pick the most affordable financing option.

 

Choose Loan Type

When financing a vehicle purchase, you’ll have to decide between a fixed rate loan or a variable rate loan. This is an important choice that can significantly impact your total loan costs.

With a fixed rate loan, the interest rate stays the same for the entire term of the loan. Your monthly payments don’t fluctuate and are predictable. This makes budgeting easier. While fixed rates are often a bit higher than variable rates initially, they provide stability and prevent payments from going up if interest rates rise.

A variable rate loan has an interest rate that changes periodically, often tied to the prime rate. Your monthly payments can go up or down each time the rate adjusts. While variable rate loans typically start with a lower interest rate, there’s risk that rates increase over time, raising your total loan costs. You also can’t anticipate what your payment will be month-to-month.

In most cases, a fixed rate auto loan is the smarter choice. The peace of mind of consistent payments usually outweighs the slightly lower starting rate of a variable loan. However, if you plan to pay off the loan very quickly, a variable rate loan could potentially save you money.

When reviewing loan offers, carefully compare the fixed and variable rates. Do the math to see projected total interest costs over the loan term. While variable rates seem enticing, the stability of fixed rate financing is often the best approach for financing a vehicle.

 

Calculate Total Costs

When financing a car, it’s important to calculate the total costs beyond just the purchase price. This includes fees, interest, taxes, and insurance. Here’s a breakdown of what to factor in:

 

Fees

Lenders often charge fees when originating an auto loan. Common fees include:

 

  • Origination fee – A flat fee to process the loan, usually 1% of the loan amount.
  • Documentation fee – Covers paperwork costs, averages around $300.
  • Title and registration fees – Varies by state, usually $20-$150 total.

 

Interest

You’ll pay interest on the financed amount over the full loan term. The interest rate greatly impacts total costs. For example, a $30,000 loan at 6% over 5 years equates to around $5,000 in interest paid.

 

Down Payment

A down payment reduces the amount financed and interest owed. A 20% down payment on a $30,000 car would save over $1,000 in interest compared to 0% down.

Add up all costs – fees, interest, taxes, insurance – when comparing auto loan offers. This gives the full picture of what financing will cost over the loan term.

 

Visiting Dealerships with Your Pre-Approval

Once you have secured auto loan pre-approval, it’s time to start visiting dealerships and test driving vehicles. Bring copies of your pre-approval letter to show salespeople you are a serious buyer.

The pre-approval gives you leverage in negotiations, as the dealer knows you are qualified to purchase at your pre-approved amounts. Be sure to only reveal details of your pre-approval terms if absolutely necessary during discussions.

As you test drive cars, focus on finding the right vehicle for your needs and budget. Don’t get caught up in the sales tactics urging you to pay more than you can afford. Having that pre-approval letter keeps you grounded in what you’ve already been approved to spend.

When you find a car you love, now is the time to negotiate the best possible price. Reference your pre-approval details and amounts to request a total price from the dealer that allows room for their financing fees and accessory add-ons.

Before signing any paperwork, thoroughly inspect the vehicle for any defects, damage or wear and tear. Test all features and functions to ensure everything works properly. This is your last chance to walk away or ask the dealer for repairs before finalizing the deal.

Bring your pre-approval letter to the finance office when it’s time for final paperwork. The dealer will likely try to get you to use their financing for extra profit. Stick to your pre-approved loan unless the dealer miraculously offers significantly better rates and terms.

 

Review Final Loan Terms

When you have selected the vehicle you want to purchase and negotiated the final price with the dealership, it’s time to review the final loan terms before signing any paperwork. This is a critical step, as the final loan details may differ from the initial loan offer you received. It’s important to verify that the interest rate, fees, and other terms are exactly what you agreed to.

Specifically, you’ll want to check that:

 

  • The interest rate matches what was originally quoted. Rates can sometimes change at the last minute.
  • There are no unexpected fees or charges added beyond what you already discussed.
  • The loan length and down payment are correct.
  • There are no expensive extras like extended warranties or service contracts added to the loan unless you explicitly approved them.

 

Review the loan documentation closely and make sure everything is in writing before signing off. Dealerships can sometimes try to tack on extra items hoping you won’t notice; don’t let that happen to you. If any part of the deal has changed, take time to thoroughly understand why and determine if it still meets your needs and budget.

Getting all the final loan details in writing protects you as the buyer. Never feel rushed into signing; it’s perfectly acceptable to take some time to review the paperwork in full. You want to be 100% confident that the financing terms are exactly what you agreed to before driving off the lot. Taking these steps helps ensure there won’t be any unpleasant surprises down the road.

 

Inspect Vehicle Thoroughly Before Signing Paperwork

Once you’ve negotiated the final price and loan terms for your desired vehicle, it’s crucial that you take the time to thoroughly inspect the car before signing any paperwork. Don’t let the excitement of your new ride distract you from doing your due diligence at this important stage.

Take the car for an extensive test drive, testing all the features and functions. Drive on different road surfaces and at highway speeds. Check that the engine, transmission, steering, and brakes are operating smoothly. Make sure all lights, signals, wipers, radio, and accessories are working.

Give the interior and exterior a meticulous inspection. Look for any scratches, dents, stains, or other cosmetic issues. Examine the tires and check tire tread depth. Verify that all VIN numbers on the car match the paperwork.

Don’t hesitate to bring the vehicle to your own trusted mechanic for a pre-purchase inspection. This will identify any issues not apparent from a test drive. It provides peace of mind that you’re not buying a lemon.

Review the final paperwork carefully before signing anything. Make sure all details match what you agreed upon, and don’t sign until you’re 100% satisfied. This final inspection protects you and your investment.

 

Sign Paperwork

After you’ve negotiated the final price and nailed down the auto loan details, it’s time to sign the paperwork to finalize the deal. But don’t rush through signing documents – take the time to carefully review everything first.

The purchase paperwork will include the final sales contract, which lists the agreed upon price, trade-in value, fees, taxes, etc. Read this over carefully to make sure it matches the negotiated deal. There will also be loan documents that spell out the exact terms of your financing agreement. Scrutinize the interest rate, payment schedule, fees, and all other loan details before signing.

In addition to the sales and loan contracts, you’ll need to sign paperwork related to extra protections like extended warranties, GAP insurance, maintenance plans, etc. Only agree to what makes sense for your situation. Don’t let yourself get pressured into unnecessary add-ons.

Dealers will often try to rush buyers through signing documents, so they don’t scrutinize everything as carefully as they should. Don’t let yourself get caught in this trap. Insist on taking the time you need to read everything before inking your signature. It can save you from an expensive mistake down the road.

Buying a car is a major financial decision – protect yourself by reviewing all paperwork thoroughly before signing on the dotted line. Never sign anything you don’t fully understand or agree with.

 

Make Timely Payments

One of the most important things when financing a vehicle is to make your monthly payments on time. Making late payments can result in penalties, fees, and damage to your credit score. Here are some key reasons to pay your auto loan on time every month:

 

  • Avoid late fees – Most lenders will charge a late fee, usually a percentage of your monthly payment, if you miss the due date.
  • Prevent interest rate hikes – Many auto loan contracts allow the lender to increase your interest rate if you make late payments.
  • Maintain good credit – Payment history is a major factor in credit scores. Late payments will lower your score, while on-time payments will help improve it.
  • Keep loan in good standing – Defaulting on an auto loan due to missed payments can result in the lender repossessing the vehicle.
  • Renew registration – In some areas, you may need to show proof of current auto loan payments to renew your vehicle registration.

 

Setting payment reminders, enrolling in autopay, and budgeting properly are all great ways to avoid missed payments. Having a good payment history will make qualifying for future loans much easier. So be sure to make those auto loan payments on time every month!

 

Pay Down Principal

One of the best things you can do once you have a financed vehicle is to start paying extra each month toward the principal balance. The principal is the amount you originally borrowed – it does not include any interest or fees. By paying additional money directly toward the principal, you can pay off your loan faster and reduce the total interest you pay over the life of the loan.

There are several major benefits to making extra principal payments on your auto loan:

 

  • You pay less interest – Since interest is calculated each month on the outstanding principal balance, paying down the principal faster means less interest accrues.
  • You can pay off the loan early – By paying extra principal consistently, you may be able to pay off your auto loan years earlier than the original term.
  • You can save money overall – Paying less interest and shortening the loan term means you pay less in total for your financed vehicle.
  • You build equity faster – Equity is your ownership stake in the vehicle. Extra principal payments help you build equity quicker.

 

Even relatively small extra principal payments can make a big difference. For example, on a $20,000 loan at 4% interest over 5 years, paying just $50 extra per month would let you pay off the loan almost 10 months early and save over $500 in interest costs. The savings and other benefits grow with larger extra payments.

Paying down the principal faster helps you maximize the value of financing your vehicle purchase. Just make sure your loan doesn’t penalize you for prepayments if you want to go this route. The earlier you start making extra principal payments, the more money you can potentially save over the life of your auto loan.

 

Refinance for Lower Interest Rates

After you’ve been paying on your auto loan for a year or more, it can be worthwhile to check if refinancing could get you a lower interest rate. Refinancing replaces your existing loan with a new one that has different terms. Here are some tips on when and how to refinance an auto loan:

 

  • Wait until you have 20-30% equity in the vehicle before refinancing. Having this cushion means the loan balance isn’t higher than the car’s value.
  • Check your credit score – if it has improved significantly since you got the original loan, you may qualify for better refinance rates.
  • Research current interest rates at banks, credit unions, and online lenders to see if you can get at least 2% lower APR.
  • Calculate the costs to refinance, like appraisal fees, to ensure the monthly savings outweigh the expenses.
  • Choose a refinance term that fits your budget while allowing you to pay off the loan as fast as possible.
  • Review the revised payoff schedule to make sure the lower interest rate results in real savings.

 

Refinancing your auto loan when the timing is right can potentially save you hundreds or thousands of dollars in interest charges. Just be sure the math makes sense for your situation before taking the refinancing plunge.

 

Celebrate Paying Off Your Auto Loan!

After months or years of making timely payments, you will eventually reach the finish line and pay off your auto loan completely. This is an exciting accomplishment worth celebrating!

Owning your vehicle free and clear is a great feeling. You’ll have the title in your hands and no more loan payments to worry about each month. Take a moment to congratulate yourself on reaching this finance milestone.

To commemorate the occasion, you can hold a small ceremony with family and friends if you want. Share the good news on social media. Frame your paid-off loan documents to always remember your achievement.

With the auto loan out of the way, you’ll have extra money previously going toward the monthly payments. Use some of the surplus funds to pamper yourself – plan a weekend getaway or nice dinner out. You’ve earned it after so diligently paying off your loan.

Completing the loan repayment on a major purchase like a car takes discipline and perseverance. Celebrating the accomplishment makes all the hard work worthwhile. It’s the final step in the auto financing process, leading to the excitement of fully owning your vehicle.

 

Conclusion

Financing a vehicle can seem daunting, but breaking down the process into clear steps makes it much more manageable. The key things to remember are checking your credit first, getting pre-approved for financing, carefully comparing loan offers, reviewing all terms and fees, and inspecting the vehicle thoroughly before signing. Making payments on time and paying down the principal quickly are vital once you own the vehicle.

Following this financing process helps ensure you get the best loan terms and end up with an affordable vehicle you love. While it requires effort on the front end, the payoff of celebrating your paid-off auto loan makes it all worthwhile. With the right preparation and knowledge, you can have a smooth and successful experience financing your next car purchase.

 

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Questions About How Car Financing Works

Car financing in Canada involves borrowing money from a financial institution like a bank, credit union or dealership to purchase a vehicle. The lender provides the funds upfront to pay for the car, and you agree to pay the money back over a set repayment period, typically between 24 and 84 months, along with interest.

Car loans in Canada work by allowing you to finance the purchase of a new or used vehicle over several years instead of paying the full cost upfront. You borrow a set amount from a lender and repay it in monthly installments over a fixed term along with interest charges. The vehicle acts as collateral on the loan.

The main steps to get car financing in Canada are:

 

  1. Check your credit score

 

  1. Get pre-approved for financing

 

  1. Determine your budget and down payment amount

 

  1. Shop for the car you want

 

  1. Finalize loan details with the dealer

 

  1. Review and sign loan paperwork

The main types of car loans available in Canada include:

 

– New car loans – For purchasing brand new vehicles

– Used car loans – For purchasing second-hand vehicles

– Private sale loans – For financing a car bought from an individual seller

– Personal loans – General consumer loans used to buy any type of car

– Secured car loans – Loans requiring the car as collateral

– Unsecured car loans – Loans that don’t require collateral

The main factors that determine your car loan interest rate in Canada are your credit score, the loan term, the age and value of the vehicle, whether the loan is secured or unsecured, and current interest rates at the lending institution. Lenders also consider your debt-to-income ratio.



To get approved for car financing from most lenders in Canada, you typically need a minimum credit score of 600. However, interest rates are highest for borrowers with scores below 660. A score of 720 or higher will qualify you for the very best rates on a car loan in Canada.

When getting car financing in Canada, lenders typically recommend a minimum down payment of 10-20% of the vehicle purchase price. The more you put down, the lower your loan amount will be, which saves on interest charges over the loan term. Putting 20% or more down also improves the chances of getting approved.

Common fees associated with car financing in Canada include:

 

– Interest charges

– Documentation fee

– Lien registration fee

– Appraisal fee

– Loan processing fee

– Credit report fee

– Prepayment penalties (sometimes)

 

Always ask lenders to explain all fees upfront before signing your auto loan agreement.



Tips for getting the lowest interest rate when financing a car in Canada include:

 

– Having a credit score over 720

– Getting pre-approved before shopping

– Comparing rates from multiple lenders

– Putting 20% or more as a down payment

– Choosing a shorter loan term (e.g. 36 months)

– Picking a fuel-efficient, gently used car

– Becoming a member at a credit union

Yes, getting pre-approved for car financing before visiting dealerships is highly recommended in Canada. Pre-approval provides you with bargaining power to negotiate the best price on a vehicle, since the dealer knows you already have financing locked in at a set rate. Pre-approval also simplifies and speeds up the final loan process.

The best places to get pre-approved for car financing in Canada are:

 

– Your bank or credit union

– Online lenders like RateHub and Loancanada.com

– Major banks like RBC, TD, Scotiabank, BMO, CIBC

– Dealerships (manufacturer financing deals)

– Credit unions like Coast Capital Savings

Yes, making extra or accelerated payments on your auto loan in Canada can save you substantially on interest charges over the full repayment term. Even small extra payments go directly to the principal loan balance. You can make one-time lump sum payments or permanent monthly payment increases through your lender.



If you default on your auto loan payments in Canada, the lender can legally repossess your vehicle and sell it to recoup their money. You would lose the any money invested in the car. The lender can also sue you for the remaining loan balance plus fees if the resale value doesn’t cover the outstanding amount. Default also damages your credit score severely.



Yes, you can trade in a vehicle in Canada that you still have outstanding loan payments on. The process involves rolling the unpaid balance from your old loan into a new auto loan for the replacement vehicle. This is called negative equity financing. You end up financing both the old loan and the balance of the new car price.

Leasing a car in Canada involves paying to drive the vehicle but not taking ownership. Monthly payments cover vehicle depreciation plus interest but are usually lower than financing payments. At the end of the lease term, which is typically 2-3 years, you return the car instead of paying off a loan. Lease down payments are also usually lower.

Pros of leasing instead of financing a vehicle in Canada include:

 

– Lower monthly payments

– Little or no down payment required

– Driving a new car every 2-3 years

– Not dealing with trade-in or resale values

– Latest features and technology

– Warranty coverage during the lease



Cons associated with leasing instead of financing a car in Canada:

 

– Never owning the vehicle

– Annual mileage limits typically apply

– Higher risk of fees for excess wear & tear

– Potential early termination penalties

– No option to sell or trade in early

At the end of a car lease agreement in Canada, you have three options:

 

  1. Turn the vehicle back in to the dealer
  2. Use any purchase option to buy it
  3. Trade it in and apply equity to a new lease

 

Any excess kilometers driven or vehicle damage beyond normal wear & tear leads to end of lease fees. The dealer will conduct a full inspection when you return the car.



The worst car loan terms to avoid in Canada are:

 

– No money down loans

– Loans over 6 years / 84 months

– Prepayment penalties

– Variable interest rates

– Balloon payment loans

– Dealer financing above 8% interest

 

Always carefully review the loan contract and ask questions before signing vehicle finance paperwork.

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