How Does Financing a Car Work?

Quick Answer

Financing a car means getting a loan from a bank, dealership or other lender to pay for the vehicle. Good credit can make it easier to finance a car.

Two vintage cars in Havana Vedado, Cuba

Are you thinking of buying a new car? Unless you have significant savings, paying for that new ride will probably require financing. Car prices rose by 13.5% in the past year, with new car buyers in the U.S. paying an average of $48,528 as of May 2023, according to Cox Automotive. Car financing works by obtaining a loan from a bank or other lender to cover the cost of the vehicle.

What Is Financing a Car?

When you buy a car, you usually make a down payment equal to a percentage of the car's price. You then borrow, or finance, the remainder of the car's purchase price from a bank or other financial institution and use the loan proceeds to buy the car.

Auto loans are a form of installment credit. You repay the loan, plus interest, in regular monthly payments over a set time period (known as the loan term). The vehicle serves as collateral on the loan: If you don't make your payments, the lender can repossess your car.

How Do Car Loans Work?

To understand how an auto loan works, there are some important terms you should know.

  • The down payment is the amount of cash you need to put down to take out the loan. Making a down payment of at least 20% of the loan amount generally results in better loan terms. Because cars depreciate about 20% in the first year, a 20% down payment also protects you from owing more than your car is worth. A larger down payment means borrowing less—and paying less interest over the life of the loan.
  • The annual percentage rate (APR) of a loan reflects the total cost of borrowing money, including the interest on the loan and any fees or other charges. Comparing APRs is a good way to compare apples to apples when weighing multiple loan offers. The APR you qualify for depends on a range of factors, including your credit score, your down payment and the length of the loan.
  • The monthly payments are the amount you pay the lender each month to repay the loan. Monthly payments include both principal and interest. Ideally, your monthly car payment should be 10% or less of your take-home pay. If your monthly payments are too high for your budget, you might have trouble paying them. Missed payments can hurt your credit score. Miss too many payments, and the lender could repossess your vehicle.
  • The loan term is how long it takes to repay the loan. You can find car loan terms from 36 to 72 months or more. As car prices rise, 84-month and even 96-month auto loans have become more common as a way to keep monthly payments manageable. Although longer loan terms mean lower monthly payments, they generally mean higher interest rates and more interest paid over the life of the loan. Choosing a shorter loan term will increase your payments, but usually lowers your interest rates, so you pay less over the life of the loan.

Even if interest rates for both loans are equal, a longer-term loan will cost more in total interest. Suppose you borrow $35,000 at an interest rate of 6.58% (the average for a new car loan in the first quarter of 2023, according to Experian data). With a 48-month loan, your monthly payment would be $831.32, and you'd pay $4,903.14 in interest over the life of the loan. Stretch your loan term to 84 months, and your monthly payment drops to $521.09, but total interest paid rises to $8,771.30.

How to Finance a Car

You can get auto loans from banks, credit unions, online auto lenders and online marketplaces, where you can compare offers from multiple lenders. Most auto dealerships also offer financing; however, you'll generally secure the best loan rates by getting preapproved for a loan elsewhere before visiting the dealership. The lender will provide a preapproval letter stating how much you can borrow and the interest rate. You can show the auto dealer the letter and see if they can beat the terms.

To finance a car, follow these steps:

  1. Figure out how much you can afford. Consider your income, expenses and existing debt when weighing how much car you can afford. In addition to the sticker price, don't forget the additional costs of buying a car, such as taxes, fees, warranties and maintenance contracts. Rolling these expenses into your auto loan lowers your initial out-of-pocket outlay but means higher car payments.
  2. Check your credit report and credit score several months before shopping for loans. This gives you time to work on improving your score, which can help you qualify for lower interest rates.
  3. Shop around. Compare auto loan terms from a variety of lenders. You can easily do this online at individual lenders' websites or using an auto loan marketplace.
  4. Get preapproved. Apply for loans from multiple lenders to see which offers the best terms. (You can use this car payment calculator to plug in various loan amounts, interest rates and terms for comparison.) An auto loan application causes a hard inquiry on your credit report, which can temporarily ding your credit score a few points. Complete all your loan applications within a few weeks, however, and credit scoring models will treat them as one inquiry. That helps keep any negative impact on your credit to a minimum.
  5. Visit the dealership and choose the car you want. See if the dealer can offer better loan terms than your preapproval.
  6. Choose the best loan option, finalize the loan and buy the car. Choosing the shortest loan term that has affordable payments will save you money on interest.

What Credit Score Do I Need to Finance a Car?

There's no one minimum credit score needed for an auto loan. Different auto lenders may use different credit scoring models and have their own criteria for assessing your creditworthiness. Factors such as your debt-to-income ratio, employment and the size of your down payment can also affect your odds of approval.

In general, however, having good or exceptional credit makes it easier to get approved for car loans, giving you more options and better loan terms. If you have fair credit, you'll have fewer loan options. You may have to make a bigger down payment, pay higher interest rates or face other restrictions.

It's possible to get a car loan even with poor credit, but it will cost more than if you have a high credit score. On average, a person with a FICO® Score of 500 (poor) would pay an average 14.08% interest rate on an auto loan, according to Experian data from May 2023. That's nearly triple the 5.18% a person with a FICO® Score of 800 (exceptional) would pay.

The Bottom Line

If you have poor or fair credit, taking steps to improve your credit score before you apply for auto loans can help you qualify for lower monthly payments and lower interest rates. Signing up for Experian Boost®ø can also help increase your Experian credit score by giving you credit for paying utilities, streaming services and other bills on time. Put in the effort to clean up your credit, and you could be driving the car of your dreams sooner than you think.