How Does Financing a Car Work?

How Does Financing a Car Work? article image.

Are you dreaming of buying a new car? As of January 2020, the average cost of a new vehicle was $37,851, according to industry analysts at Kelley Blue Book—so if you're like most of us, you'll need to get financing to make your dream a reality. Car financing works by providing a loan from a financial institution or other lender to cover the total cost of your purchase.

What Is Car Financing?

When you finance a car, a financial institution lends you the money you need to pay for the vehicle in the form of installment credit. You'll typically need to make a down payment equivalent to a percentage of the loan amount, then repay the rest of the vehicle's purchase price over a set time period (the loan term) by making regular monthly payments.

As with any loan, auto lenders make money by charging you interest on the loan and additional fees for processing and issuing the loan. The car itself acts as collateral on the loan, which means the lender has the right to take (repossess) your car if you can't keep up with your payments.

Who Offers Car Financing?

You can get auto financing through a variety of financial institutions. Banks and credit unions are common places to get car loans. If you have a general idea how much the car you want will cost, you can contact your bank or credit union and get preapproval for a loan. They'll give you a letter confirming the amount you can borrow and the interest rate. Just be aware interest rates may change a bit when you actually purchase the car and the bank or credit union runs a complete credit check to finalize your loan approval.

You can also find online auto lenders and online marketplaces that can match you with the best car loan for your needs. These sites typically let you compare offers from several lenders to find the one that works for you.

Another place to get financing is the auto dealership itself. Dealerships may arrange financing for you through outside lenders; you'll apply for a loan at the dealership and get approval on the spot. This may cost a bit more than getting a loan on your own, since dealerships generally build some profit for themselves into the cost.

Some dealerships offer their own in-house financing. Known as "buy here, pay here" financing, this is something to avoid if at all possible. These loans are designed for people with bad credit, so interest rates and down payment requirements tend to be very high.

If you wait until you've fallen in love with a particular car to apply for financing at the dealership, you may be more likely to accept less-than-ideal loan terms. That's why getting preapproved for an auto loan on your own before you visit the dealership can be a smart idea. Armed with your preapproved loan terms, you can negotiate for better terms and get the right auto loan for your needs.

What Credit Score Do I Need to Finance a Car?

The credit score needed to qualify for a car loan varies based on the lender and the type of financing. Auto lenders may even differ in the credit scoring model they want to use to assess your creditworthiness. As a result, there isn't one set minimum credit score that all lenders require. That said, people with higher credit scores and longer credit histories can generally qualify for better loan terms and lower interest rates.

If your FICO® Score is good or better, you should be able to qualify for favorable auto loans. A score in the "fair" range usually won't keep you from getting approved; however, it may mean you'll pay higher interest rates or have to make a bigger down payment. If you have a poor credit score or simply want to qualify for the best possible terms, spend some time working on your credit score before you apply for an auto loan.

Things to Keep in Mind When Applying for a Car Loan

The sticker price of the car isn't the only cost to consider when applying for car financing. Here are some key terms you need to be aware of.

  • Down payment: The amount of cash you need to put down to take out the loan. If you have good to excellent credit, you may be able to qualify for zero-down-payment offers. When deciding your down payment amount, remember that the more you put down, the less money you need to borrow—and a smaller loan means you'll pay less interest over time.
  • Annual percentage rate (APR): Your loan's APR will include the interest rate for the loan as well as any fees or other charges to reflect the total cost of borrowing money. If you're weighing two loan offers, comparing the APR is a good way to assess which loan will cost you more in the long run.
  • Taxes: State sales taxes on vehicles must be paid at the time of purchase. Depending on where you buy the car and how much it costs, this can add several thousand dollars to your cost.
  • Fees: In addition to the fees to register your new car with your state's motor vehicle department, you may have to pay other fees charged by the dealership, such as destination or documentation fees.
  • Terms: The term is how long you have to pay back the loan. Auto loan terms generally range from 36 to 72 months; you can even find 84-month auto loans. Choosing a longer loan term will lower your monthly payments, but at the cost of paying more interest over time. A shorter loan term means higher monthly payments, but lower interest payments overall; in addition, lenders often offer lower interest rates for shorter-term loans.
  • Monthly payments: To repay your auto loan, you'll make set monthly payments that include both principal and interest. Experts advise keeping your monthly car payment to 10% or less of your take-home pay. It's important to keep the monthly payment manageable, because if you have trouble paying your car loan, it could hurt your credit score—and if you miss too many payments, your car might be repossessed. Ideally, look for the shortest loan term with affordable payments.

Alternative Types of Auto Financing

Traditional auto loans aren't the only way to secure and pay for a car. Here are some other options that may work for you.

  • Leasing a car: Leasing offers a way to drive a new car without buying it. A lease is essentially a long-term rental, so you'll return the car to the dealership or leasing company after driving it for a few years. Monthly lease payments are generally lower than a loan payment for the same car would be. Leasing a car typically requires a down payment and fees, and you may have to put up with some restrictions—there may be a limit on how many miles you can drive each year, for instance. However, if your goal is to drive the latest vehicle without making a big investment, leasing could be an option. Just keep in mind you'll need good to excellent credit to qualify for most leases.
  • Paying cash: Paying for a car in cash isn't feasible for most people, especially if you have your heart set on a brand-new model. But for those who can manage it, paying cash eliminates the need to take out a car loan. Chances are, you'll need to save up a few thousand dollars for a down payment anyway. If you don't need the car immediately, take the time to save up a little more. As long as you don't need all the bells and whistles and just want basic transportation, you can find reliable used cars for $5,000 or less.
  • Peer-to-peer lending: Peer-to-peer (P2P) loans are made not by banks or car dealerships, but from one individual to another. These are personal loans you can use for any purpose, including buying a car. You can find P2P loans on online platforms, such as Prosper, Lending Club and Peerform, that match you with individuals willing to issue loans. Interest rates on P2P loans can vary widely, and you'll generally need good credit to get approved; however, it's easy to apply online and compare different interest rates and terms to find the best peer-to-peer loan.

The Best Way to Finance a Car

As you can see, there are plenty of ways to finance your new car. To get the best possible auto loan, start by checking your credit report and credit score. A good credit score gives you more choices and can help you get better loan terms. Investigating car loans from your bank, credit union and online lenders before you visit an auto dealership will give you a clear idea of your options, putting you in a strong position to negotiate favorable financing for your new wheels.

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