Buying a car outright is the fastest way to own a car. However, the option to pay in full is out of reach for many people — especially these days. U.S. Census Bureau data shows that only about 37.5% of U.S. households are earning over $100,000 per year.Meanwhile, the average new car costs about $50,000, according to CNBC.
With this tight math, it’s not surprising that financing a car can be a more manageable method for most consumers. But how does car financing work?
Put simply, when you finance a car, you borrow money from lenders to purchase a vehicle. Instead of paying the full purchase price upfront, you make regular payments to the lender, including interest, over a specified period. Then, when the term is done and you’ve made all of your payments, the car is officially yours.
While this process may seem straightforward, there are several critical things to know about car financing— and where it can go wrong. This article covers what you should know about buying vehicles with financing, including how to get a car loan, common loan terms, tips and car financing FAQs.
How Does Car Financing Work?
Car loans involve borrowing money to purchase a vehicle and then repaying that loan over time, typically with interest. Instead of paying the entire cost of a car up front, you take out a loan with a lender and pay a set amount each month.
In brief, when financing a car, you:
- Start by applying for a loan through a bank, dealership, or other lender.
- Get loan approval with terms such as the amount, interest rate, and repay period.
- Make a down payment on the car, if required (the outstanding amount will be borrowed from the lender, i.e. covered by the loan).
- Complete and execute loan documents to take out the loan.
- Make monthly payments over the loan period.
- Transfer the title to your name once the loan is paid off in full so that you officially own the car.
You can read more details about each of these steps in the sections below.
Auto Loan Terminology
Before jumping into the steps of how to finance a car, it’s helpful to first get to know the common terms you might hear when purchasing a vehicle. You may already be familiar with some, as many are used with other types of loans.
When financing a car, here are several key terms to know:
- Down payment: The amount of cash required up front that goes toward the car purchase price when taking out a loan. As a rule of thumb, Kelley Blue Book recommends putting down at least 20% of the car’s purchase price. Example: If your car costs $40,000, your down payment should be at least $8,000.
- Loan principal: The total amount of money you borrow from the lender to purchase the car. Example: If your car costs $40,000 and you make a down payment of $8,000, your loan principal is $32,000.
- Interest rate: The basic percentage the lender charges each year for the amount of money you borrow over the loan term, which you’ll pay in addition to the monthly payment. The interest rate you’re offered often varies based on your credit score.
- APR (Annual Percentage Rate): The total annual cost of borrowing the money, including the interest rate and any additional fees associated with the loan.
- Loan term: The length of time (usually in months) you have to repay the loan in full. The lender and borrower agree on a term in the loan contract.
- Monthly payment: The fixed amount you pay the lender each month to cover the principal and interest on the loan. This is also sometimes referred to as a “car note”.
- Origination fee: A fee the lender charges to process and set up your car loan.
- Car title: An official document from the state that contains the car’s make, model, year, unique vehicle identification number (VIN) and the owner’s information.
How to Get a Car Loan in 7 Steps
Once you’re familiar with key terms, you’ll have a better idea of what to expect when applying for a car loan. Your credit health, however, is an important factor in the financing process — especially when it comes to potential auto loan interest rates.
The following steps may help you secure a car loan that works for your financial situation.
1. Determine Your Budget
The first step is to figure out how much you can afford to pay for monthly car payments. Create a budget and compare your total monthly income to your monthly expenses. Then, see how much money you can realistically spare for both one-time car purchase expenses and monthly payments.
Keep in mind that the cost of having a car goes beyond just the loan payment. Consider other car-related expenses, which can include things like:
- Taxes and fees
- Registration
- Gas
- Insurance
- Maintenance (oil changes, new tires, etc.)
- Tolls, parking passes and tickets
2. Know your important ratios
When you try to apply for a car loan, the lender will assess your financial situation in a number of ways. Two metrics they will almost certainly review are “Debt-to-Income Ratio” and your “Payment-to-Income Ratio”.
Understanding these ratios can help you gauge your financial readiness for a car loan and ensure you don’t overextend yourself. Keeping both ratios within recommended limits can lead to better loan terms and a smoother approval process.
Debt-to-Income Ratio (DTI): This metric compares how much debt you have to how much money you make. Lenders use DTI to assess your ability to manage additional debt. A lower DTI indicates better financial health that would allow you to responsibly take on more debt and increases your chances of loan approval with favorable terms.
You can calculate this yourself by dividing your total monthly debt payments by your gross monthly income. Most lenders prefer a DTI of 36% or lower to demonstrate borrowers can handle additional debt.
Example: If you earn $5,000 monthly and have $2,000 in monthly debt payments, your DTI is 40% ($2,000/$5,000 = .4 = 40%)
Payment-to-Income Ratio (PTI): This number compares your potential monthly car payment to your monthly income. It helps lenders determine if the car payment fits within your budget. To calculate your PTI, divide your expected monthly payment by your monthly gross income.
Example: If you earn $5,000 monthly and the expected car payment is $600, then your PTI is 12% ($600/$5,000 = .12 = 12%)
By keeping close track of your finances, you can work to improve these numbers and potentially get lower interest rates for car financing.
Pro Tip:
Be sure to consider only what you can comfortably afford with your current budget. Car loans are generally considered secured loans, which means if you are unable to maintain your payments, your car could get taken away.
3. Check on Your Financial Health
Next, take time to gauge your financial health. By understanding your credit situation, you can potentially make more informed decisions, ensure a smoother loan process and save money on your auto loan.
Check Your Report
Before you apply for a loan, check your credit report.
Your credit report provides a detailed history of your borrowing and repayment behavior. It includes information about your credit accounts, payment history, and any negative marks like a default or bankruptcy. Reviewing your report helps you to understand your financial health better, identify areas that need improvement, and correct any inaccuracies that could negatively impact your score. If you see something in your report that is inaccurate, file a dispute. It’s free to do online through the TransUnion Service Center.
You can access your credit report at AnnualCreditReport.com to get a fresh report every week.
You can also check your credit report for free with TransUnion. With a subscription, you’ll get your TransUnion credit report and score with daily refreshes available. Plus, you get free credit tools, alerts, insights, and personalized offers tailored to your credit profile.
Check Your Score
Before you apply, check your score too. Your credit score is a numerical representation of your creditworthiness, which lenders may use to assess the risk of lending to you. A good credit score, according to the VantageScore® 3.0 model, falls in the range of 661-780. While there is no minimum requirement, the higher your score, the better odds you have of being approved for a loan and getting more favorable terms.
How to Improve Your Credit Health
Achieving good credit can’t be done overnight. The key is to establish good credit habits and to be consistent.
Some things you can do to work on your credit include:
- Check your credit to find and fix your problem areas
- Correct any errors or inaccuracies on your credit reports
- Make on-time payments to keep your credit score in good shape
- Maintain a low credit utilization ratio, ideally under 30%
- Avoid applying for many types of credit in a short time, which can hurt your score
Pro Tip:
Check out our guide on how to read a credit report to understand the sections of your credit report. Plus, learn how the information on your report may impact your credit score.
Getting Auto-Financing with a Low Credit Score or No Credit History
If you’re applying for a car loan with no credit history, it’s still possible to qualify. Some lenders allow you to have a cosigner whose credit they’ll check instead.
If you are trying to get a car loan with bad credit, then it is possible. Some lenders may require you to make a larger down payment in order to approve a loan. Once approved, making on-time monthly payments on your car loan can help build your credit.
4. Research Car Financing Options
Once you have an idea of your credit health, shop around for car loans from multiple lenders. The following are different types of lenders and financing options for a car:
- Bank loans
- Dealership financing
- Credit unions
- Online lenders
- Special financing programs
Each one might offer their own benefits and drawbacks, so it’s important to figure out what kind of lender or loan might work best for you.
Comparing Loan Terms: Interest Rates, Duration and Other Requirements
When comparing finance options, there are a few loan terms that might vary between lenders. For each lender, look into the following:
Interest Rates: Shop around for the best (lowest) interest rates. Your credit score will significantly impact the rate you’re offered. For example, depending on your credit score, your loan interest rate could range from 5% to 20% — a major difference in cost.
You can save a lot of money by getting a lower interest on your car loan. Let’s look at a hypothetical example of how your monthly payment and total interest paid are impacted by the loan interest rate.
If you financed a new car with a $25,000 loan for 60 months, you might pay:
Getting a lower interest rate is almost like getting a discount on your car because you pay less money on your monthly payment and total interest costs on the loan. For example, comparing the difference between a 11% interest rate and 20% interest rate, you could expect to save over $7,000 in interest on this loan amount.
Loan duration: Shorter loan terms typically have higher monthly payments but lower overall interest costs. Longer terms may be more manageable monthly but can cost more in interest over time.
Other loan requirements: In addition to interest rates and loan duration, ask your lender about any loan requirements, especially if you are considering buying a used car or from a private seller (if you want to buy from an individual). These requirements can vary widely between lenders and may significantly impact your eligibility and the overall cost of the loan. Some requirements may include:
- Vehicle age and mileage limits-Vehicle inspection or appraisal
- Minimum and maximum loan amounts
- Clear title (no liens)
Leasing vs. Traditional Financing
In addition to comparing loan options, it’s also worth considering whether leasing a car might be a better fit for your needs than buying one through traditional financing.When youlease, you’re basically renting the car for a few years. You make monthly payments, but you don’t own the car. At the end of the lease, you return it or buy it.
Here are some leasing vs financing differences to consider:
- Ownership: With a loan, you own the car once it’s paid off. With a lease, you return the car at the end of the term unless you choose to buy it.
- Monthly Payments: Lease payments could be lower than loan payments, particularly if you get a special lease deal.
- Mileage Limits: Leases typically come with annual mileage limits (e.g., 10,000–15,000 miles). Exceeding these limits can result in additional fees.
- Wear and Tear: You may be charged for excessive wear and tear when returning a leased vehicle.
- Flexibility: Leasing allows you to drive a new car every few years, while financing is better if you plan to keep the car long-term.
5. Get Pre-Approved for a Car Loan
After narrowing down your lender choices, you can apply for loans with them to get “pre-approved.” Pre-approval means a lender looks at your financial information and gives you an estimate of how much money they’re willing to lend you. It’s not a final offer, but it gives you a good idea of what you can afford.
Loan pre-approval lets you see what loans you are likely to qualify for but typically requires a hard inquiry with the application. A “hard inquiry” (also called a “hard pull”) may temporarily lower your credit score.
A big benefit of getting pre-approved is that it can give yousome more negotiating leverage. When you walk into a dealership with a pre-approved loan, you’re basically acash buyer. This means:
- You canfocus on getting the best pricefor the car, not just the monthly payment.
- You areless likely to accept upsells or unnecessary add-ons and stick to your budget.
- You cancompare dealer financing to your pre-approval and choose the better deal.
To get pre-approved, you’ll likely need to provide the following to a lender:
- Proof of income and employment
- Personal information, like your full name, birthdate, and Social Security Number
- Proof of address and insurance
- Information about the car you want to buy (VIN, make, model, year, mileage, etc.)
Keep in mind that loan rate shopping can impact your credit score since pre-approval requires a lender to perform a hard credit pull. But you can reduce the impact by applying to different lenders within a short amount of time. Note that credit scoring companies treat these checks differently. VantageScore® counts all loan applications made within 14 days as just one inquiry. FICO® gives you more time—up to 45 days. By keeping your applications within these time frames, you can shop around for the best loan rates without significantly hurting your credit score.Buying a car outright is the fastest way to own a car. However, the option to pay in full is out of reach for many people — especially these days. U.S. Census
With this tight math, it’s not surprising that financing a car can be a more manageable method for most consumers. But how does car financing work?
Put simply, when you finance a car, you borrow money from lenders to purchase a vehicle. Instead of paying the full purchase price upfront, you make regular payments to the lender, including interest, over a specified period. Then, when the term is done and you’ve made all of your payments, the car is officially yours.
While this process may seem straightforward, there are several critical things to know about car financing— and where it can go wrong. This article covers what you should know about buying vehicles with financing, including how to get a car loan, common loan terms, tips and car financing FAQs.
How Does Car Financing Work?
Car loans involve borrowing money to purchase a vehicle and then repaying that loan over time, typically with interest. Instead of paying the entire cost of a car up front, you take out a loan with a lender and pay a set amount each month.
In brief, when financing a car, you:
- Start by applying for a loan through a bank, dealership, or other lender.
- Get loan approval with terms such as the amount, interest rate, and repay period.
- Make a down payment on the car, if required (the outstanding amount will be borrowed from the lender, i.e. covered by the loan).
- Complete and execute loan documents to take out the loan.
- Make monthly payments over the loan period.
- Transfer the title to your name once the loan is paid off in full so that you officially own the car.
You can read more details about each of these steps in the sections below.
Auto Loan Terminology
Before jumping into the steps of how to finance a car, it’s helpful to first get to know the common terms you might hear when purchasing a vehicle. You may already be familiar with some, as many are used with other types of loans.
When financing a car, here are several key terms to know:
- Down payment: The amount of cash required up front that goes toward the car purchase price when taking out a loan. As a rule of thumb, Kelley Blue Book recommends putting down at least 20% of the car’s purchase price. Example: If your car costs $40,000, your down payment should be at least $8,000.
- Loan principal: The total amount of money you borrow from the lender to purchase the car. Example: If your car costs $40,000 and you make a down payment of $8,000, your loan principal is $32,000.
- Interest rate: The basic percentage the lender charges each year for the amount of money you borrow over the loan term, which you’ll pay in addition to the monthly payment. The interest rate you’re offered often varies based on your credit score.
- APR (Annual Percentage Rate): The total annual cost of borrowing the money, including the interest rate and any additional fees associated with the loan.
- Loan term: The length of time (usually in months) you have to repay the loan in full. The lender and borrower agree on a term in the loan contract.
- Monthly payment: The fixed amount you pay the lender each month to cover the principal and interest on the loan. This is also sometimes referred to as a “car note”.
- Origination fee: A fee the lender charges to process and set up your car loan.
- Car title: An official document from the state that contains the car’s make, model, year, unique vehicle identification number (VIN) and the owner’s information.
How to Get a Car Loan in 7 Steps
Once you’re familiar with key terms, you’ll have a better idea of what to expect when applying for a car loan. Your credit health, however, is an important factor in the financing process — especially when it comes to potential auto loan interest rates.
The following steps may help you secure a car loan that works for your financial situation.
1. Determine Your Budget
The first step is to figure out how much you can afford to pay for monthly car payments. Create a budget and compare your total monthly income to your monthly expenses. Then, see how much money you can realistically spare for both one-time car purchase expenses and monthly payments.
Keep in mind that the cost of having a car goes beyond just the loan payment. Consider other car-related expenses, which can include things like:
- Taxes and fees
- Registration
- Gas
- Insurance
- Maintenance (oil changes, new tires, etc.)
- Tolls, parking passes and tickets
