You are ready to buy a new car. However, before you hit the dealership, you need to learn the basics of how to pay for your car. You have three options: You can pay for your car with cash. You can take out a loan, also known as financing your vehicle. Alternatively, you can lease it, an arrangement in which you basically rent the car with an option after a set number of months to buy.
What option is best for you? That depends on your financial situation.
If you can afford it, the best option is usually to pay for your car in cash. This way, you will not have to pay interest on the price tag of your new vehicle. Of course, not everyone can pay cash for a new car. After all, new cars can cost $15,000, $20,000 or more.
If you do not have the money, you'll have to either take out a loan to finance a vehicle or lease your new car for a set number of years.
Before choosing either of these options, you'll need to determine how much you can afford to pay for the car on a monthly basis. The best way to do this is to look at your debt-to-income ratio. In general, you do not want your total monthly debts, including an estimated new car payment, to equal any more than 36 percent of your gross monthly income. If a monthly car payment would push your debt-to-income ratio higher than this level, you cannot afford that new car.
Once you know you can afford a car, it is time to consider leasing or financing.
When you finance a car, you take out a loan for the purchase price. You then pay back your loan in monthly installments, with interest added to your monthly payments. You can either take out a loan with the dealer who is selling the car or with an outside lender. Often, you can nab a better deal -- with lower interest rates -- from an outside lender such as your bank or credit union.
Your interest rate, though, will depend largely on your three-digit credit score. This number tells lenders whether you pay your bills on time each month. If you do, and if your debt levels are not too high, your credit score will be high. Lenders today consider a credit score of 740 or greater on the FICO scale to be an excellent score.
If your credit score is too low, you might have to pay a higher interest rate to provide financial protection to lenders that are taking on the risk by lending to you. If your score is exceptionally low, you might struggle to qualify for an auto loan at all.
Leasing a car is a bit more complicated. Under this arrangement, you lease a car for a set number of months, such as thirty-six. You and the dealer will decide how much you want to pay upfront to lease a car. Auto experts recommend that you negotiate as low an upfront cost as possible, perhaps paying what are known as "drive-off fees" only.
Once you have your lease, you will pay, as if you were financing the vehicle, a monthly fee to continue leasing the car.
You will be allowed to drive the car a set number of miles each year -- such as 12,000 to 15,000 miles -- without paying any extra fees. If you go over those miles, you will have to pay penalties.
At the end of your lease period, you will have the option to buy your car. When you first take out your lease, you'll negotiate a residual price. Once you've completed all of your lease payments, you can purchase the car for this residual price. If you do not want to pay this, you can instead return the car to the dealer. You might face charges for excessive damage or wear-and-tear at this point.
Monthly lease payments are often lower than the monthly payment you might pay if you take out a loan to purchase a vehicle. That is because you only pay for the value of the car used during the lease term. Put another way, it is the purchase price minus the residual value of the car at the end of the lease term.
Deciding whether to lease or finance a new car -- or pay for your new vehicle in cash -- is no easy decision. There are plenty of factors to consider. If you like the idea of upgrading to a new car every three years, leasing might be a better choice. If you'd prefer to pay off your car over time and drive a vehicle without having to make monthly payments, financing your car with a low-interest-rate auto loan might make more sense.
Shopping for a new car might be the fun part. However, by researching your payment options, you'll increase your odds of landing a better financial deal once you do hit the dealership.