Photo Credit: Veridian Credit Union
If you’re looking to purchase a car (new or used), you’ve got options. You might pay for the car with cash. Perhaps you’ll borrow money from a friend or relative. Or, maybe you’ll instead choose to work with a lender.
If you’re looking to borrow through a lender, you have several different options. You might shop through your car dealership. You could contact a local bank (either a small branch, or a big national lender). Or, maybe you’ll make use of a credit union.
In our view, credit unions are the best option for financing a vehicle purchase. Below, we’ve discussed why.
How Do Credit Unions Work?
First, it’s important to understand a bit about how exactly credit unions work. In some respects, credit unions are similar to banks. Both lend money, and allow customers to open checking and savings accounts.
However, there are also some major differences between banks and credit unions. First, credit unions operate on a membership basis.
Some credit unions focus on serving certain professions, like teachers, healthcare workers, police officers, or current and former members of the military (and their families). Others are geographically oriented, and only serve those who live in certain states. Some are based on membership in a particular labor union or professional organization. Others are based on shared religious faith (i.e. membership in a church).
To join one of these credit unions, you must meet the membership criteria. Credit unions are designed to share the benefits of membership with a limited group of people, who share something in common.
Credit unions are collectively owned by their members, for the benefit of members. For this reason, credit unions are nonprofit organizations. Their objective is not to earn the most amount of money possible, but rather, to provide cost-effective, useful products to their members.
Credit unions often carry a more limited number of products than traditional banks. For example, they usually offer checking and savings accounts, but might not carry the same variety of loan and investment products. However, for your basic banking needs, a credit union should be more than sufficient.
Financing Through A Car Dealership
If you’re looking to buy a vehicle, you have a number of different options. One is to show up with cash, and pay the dealer for the car. Obviously, this doesn’t require approval from a bank, or any other lender.
Another option is financing the purchase of the vehicle through the dealer. In this situation, you’ll visit a dealer, and perhaps test drive a vehicle. At this point, you’ve probably done a bit of online research, and figured out which vehicle makes the most sense for you.
When you’ve selected a vehicle you like, you’ll sit down with someone from the car dealership’s finance department. They’ll have you fill out a loan application, where you indicate how much money you earn, and provide the lender with permission to pull your credit.
Often, the dealership will ask for proof of your income. A pay stub, or some bank statements, should usually be enough. The dealership wants to verify that you have a basic ability to pay the loan.
At this point, the dealer will sit down with you, and review your financing options. It’s very important that you understand how dealer financing actually works.
When a dealer pulls your credit and provides your borrower profile, they’re able to contact their loan partners, and find out what sort of financing they might offer you. For example, Capital One Auto Finance might tell the dealer they are willing to offer a 4 year loan (meaning, you have 4 years to pay off the car), with a 6% interest rate. Meanwhile, Santander might offer a 4 year loan, at a 7% interest rate.
These rates are known as the “buy rate.” This is the minimum interest rate at which the lender will allow the dealership to offer financing to a customer. However, there’s another interest rate you should be aware of: The “contract rate” is also known as “sell rate.”
The contract / sell rate is the interest rate which the dealer is allowed to list on the sale contract, and charge the customer. So, in the example above, Capital One might allow for a contract rate of 8%. Remember, Capital One is offering the loan at a rate of just 6%. What happens to the 2% difference?
You guessed it – the dealer gets to pocket that difference. This is known as the spread or finance reserve. In many states, there are restrictions on how much the dealer can charge as a spread, but 2% is generally fine.
The dealership will be paid this 2% difference for the life of the loan. When you consider how many cars are financed at dealerships every year, it becomes clear that this is quite a lucrative source of profits for the lender.
Let’s add another wrinkle to this scenario: What if Santander allows the dealer to offer a contract rate of 9.5%? Since Santander has a buy rate of 7%, this means that the dealership enjoys a 2.5% spread on the loan. They’ll be making more profit, and you’re paying more for the loan.
In this situation, why would the dealership even mention the Capital One financing option, where they earn less money? They have no reason to. In most cases, the dealership will try to convince you that the Santander loan is your best option.
As you can see, there’s often a conflict of interest, when financing a vehicle from a dealership. You’re probably being offered the deal that is most beneficial to the dealer- not to you.
Given these realities, why would you finance a vehicle through a dealership? There’s no good reason to do so.
The Credit Union Financing Process
To finance a vehicle through a credit union, you’ll first need to join the credit union. Often, this involves qualifying through the credit union’s membership criteria, and opening a checking account.
After that, you can apply for an auto loan with the credit union. Typically, they’ll need to pull your credit reports, and obtain proof of your income. This might involve reviewing bank statements, tax returns, and pay stubs. Remember, credit unions are owned by you and other members. Therefore, it is important that they ensure you’re qualified for the loan.
Once a credit union has approved you, they’ll provide you with a loan pre-approval letter. This will state how much you’re approved to borrow for, at what interest rate, and for how long. These are known as the loan terms.
The letter will usually also have a period which it is valid for. Usually, this is 30 to 60 days.
What this means is that if the 30 or 60 days passes, you’ll need to obtain a new, updated pre-approval letter. Until then, however, you can shop for a loan at the terms offered on the letter.
Keep in mind that the amount you’re approved for is not the only expense you’ll face. You’ll also need to budget for taxes, licensing and other fees. You’ll want to carefully calculate what you can afford. When it comes to loans, you must avoid getting in over your head.
Purchasing With A Credit Union Pre-Approval Letter
When you visit an auto dealership with a pre-approval letter in hand, you’re already in a stronger position. When the salesperson at the dealership starts talking about monthly payments and financing, you can inform them that you’re already approved for financing. Therefore, you’re only interested in discussing the price of the vehicle.
This allows you to save money, and thus negotiate more effectively. Remember, many car dealerships use financing as a profit center. By obtaining your own financing, you force them to offer you savings elsewhere.
The Final Word
Shopping for a vehicle is an involved process. You have to figure out which model makes the most sense for you, and do your research. You then have to figure out how to pay for the car.
It’s tempting to engage in one-stop shopping. It is convenient to buy a car from a dealership, and obtain financing from them at the same time. Yet, over the medium to long run, it costs you more.
For these reasons, consider joining a credit union. You can find a list of credit unions that virtually anyone can join, as well as a broader list of credit unions here.
