How to Finance a Car

A Step-by-Step Guide to Auto Financing - Shopping for a new car is much more thrilling than applying for a car loan. Because of this, it's often the last thing that auto consumers consider, despite the fact that it ought to be the first. Naturally, finding the ideal car for your needs and budget is essential, but figuring out how to pay for it and applying for a car loan should be dealt with early on in the process.

Few consumers can afford to pay the full cash price for a new or used car. Instead, you'll need to obtain an auto loan to pay for all or a significant portion of the cost of the vehicle.

The COVID-19 pandemic has hastened the adoption of hassle-free online auto loan options, much like it did for most other aspects of the car buying process. Now, you can quickly compare lenders and apply for loans while watching Netflix on the couch.

You'll have a better notion of how much automobile you can buy after you know how much you can borrow, what interest rate you qualify for, and how long of a loan lenders are willing to offer. While choosing the incorrect vehicle loan might cost you money and harm your credit, choosing the right one can save you money.

An auto loan payment is just one piece of the cost of owning a new or used vehicle – there's also fuel, maintenance, insurance and parking. Your monthly payment needs to fit into your budget, while at the same time paying down the balance as quickly as possible.

Erin Klepaski, executive director of strategic alliances at Ally Financial, advises consumers to "do their research and make sure it's not simply about 'oh, I want to spend $300 a month'." "Really make sure that vehicle suits your needs - that you can insure it, that the fuel economy makes sense for you, that you can drive as many miles as you need, that it has the functionality that you need, so that you get that whole package and that total cost of ownership experience, as opposed to just shopping the vehicle payment."

Car purchasers frequently postpone thinking about financing until they are in the financing department of a car dealership. Unfortunately, doing that could lead to paying too much for your auto loan and perhaps leading to financial ruin. Before they ever consider visiting a dealership, savvy car buyers are aware of the exact amount of car they can afford and have a plan in place for financing their new ride. Even if the dealer arranges financing for you, they won't be motivated to provide you a better bargain if they don't have a competing offer.

1) Learn the Language of Lending

There are some essential terms that you’ll want to understand before you begin your auto financing adventure. Here are a few of the most important:

Car Loan (also auto loan, car financing): A car loan is a contract between you and a lender where they agree to provide you with the cash to buy a new or used car, and you agree to pay the money back over time. Unless you get a 0% financing deal, you'll have to pay interest each month on the loan balance. Some lenders will also charge you a loan fee.

Interest (also Finance Charge): Interest is the cost of borrowing the money from the lender. It is expressed as an interest rate (often called the annual percentage rate or APR). The interest covers the lender’s costs and risks while providing them with a profit margin. A loan's interest rate will be specified in the loan papers.

Interest rates fluctuate over time. For several years, auto loan rates were near historic lows. They are now slowly climbing toward a more historically normal range. The annual percentage rate you'll pay is affected by a multitude of factors, including some you can control and many you can't. Your personal credit history, the length of the loan that you're seeking and even the type of vehicle that you're buying can significantly affect the rate you'll be asked to pay. Different lenders can offer significantly different interest rates for the same vehicle purchase.

Car Loan Term: The loan term is the length of the auto loan, and it’s typically expressed as a number of months. Loan terms of 36 to 48 months were once the most common lengths. As cars have gotten more expensive, however, loans with terms of 60 to 72 months or even longer are widely available. It’s a good idea to divide the loan term by 12 to see the number of years that it will take to pay off the vehicle.

Longer loans mean more risk for lenders, so they typically come with higher interest rates. You generally want to get the shortest loan you can afford. Having a shorter loan helps you to avoid the possibility that you’ll still be trying to pay off your car at the same time as the car’s age leads to ever-more costly repairs. You don’t want to be faced with the choice of paying for repairs or having the money to make your monthly car payment.

Principal: The loan principal is the balance of the loan. When you first take out the financing, it will be the total loan amount. As you make monthly payments, the principal will decline. With each payment, a portion will go toward interest and the rest will pay down the principal.

Down Payment: A down payment is an amount of money that you pay toward the purchase of the car when you initially buy it. It can come in the form of a cash payment, your trade-in or both. The amount you’ll have to finance is the difference between the price of the car and the amount of the down payment. For example, if you buy a $40,000 minivan and pay a $10,000 down payment, you’ll have to finance $30,000.

Monthly Payment (or Car Payment): Each month, you’ll be required to make a payment toward the loan’s principal and interest. Monthly payments will be equal and have a specific due date.

Figuring out the monthly payments on a specific loan requires relatively sophisticated math, as you'll be paying a bit less interest each month as the loan balance declines. Fortunately, you can quickly find an answer by plugging a few numbers into our car payment calculator.

It's crucial that you look at the cost of the car plus the total cost of interest when comparing auto loans. Focusing on the monthly payment, the number of months you'll be paying or the interest rate alone won't give you a complete picture of the total cost of the vehicle.

Credit Score: A credit score is a three-digit number that represents a credit reporting agency's analysis of your credit history. The higher the score the better. It's based on several factors, including your history of making on-time payments, the amount and types of credit you have, and the amount and types of credit you're using.

Vehicle Title: A state-issued slip of paper that proves ownership of a car. It first goes to the company that makes your auto loan. Until you completely pay off the loan, the lender will hold the title to the vehicle.

Loan to Value Ratio: The ratio of the loan balance to the cash value of the car. You want this number to be less than 100%. If it's 100% or more, you're considered underwater on your car loan.

2) Know Your Credit Score and Understand Why It Matters

Your credit score is a snapshot of your creditworthiness and your ability to repay an auto loan (or any other type of loan or credit card). It is essentially the information from your credit report boiled down to a three-digit score. Higher numbers indicate there’s a good chance of a borrower paying back a loan. Lower numbers show a greater probability that a borrower will default on their loan.

You actually have several credit scores, as different credit reporting companies use different methods to determine scores. The three main credit bureaus are Experian, TransUnion and Equifax. Sometimes your credit score will be referred to as your credit rating or FICO score, though a FICO score is just one type of credit score available to lenders. Most credit-scoring models range from 300 to 850 points, though some use other scales. Scores from one scoring model are not directly comparable to those from other models.

If you have a high credit score, getting a car loan with a low interest rate is more likely than if you have a lower score. Consumers with lower scores will generally have a harder time getting a loan and can expect to pay a higher interest rate on their loan. If you have steady employment and a score of 720 or above on most scales, you should not have any problem getting financing.

What Goes Into a Credit Report?
The two most important factors are your history of making on-time payments and whether or not you have been delinquent or defaulted on any financial obligations. The more often you have been late, the more points will be deducted from your score. If a lender has had to write off a balance that you left unpaid, you’ll have a derogatory mark on your credit for several years.

Next is the amount you owe compared to the amount of credit that you have available. If you are utilizing 90% of the credit that you have available, for example, it will hurt your credit score more than if you’re just using just 30% of your available credit. If you are considering closing credit cards, wait until you get your auto loan. Closing cards reduces your availability of credit and raises the percentage of your credit that you are utilizing, hurting your score.

Less critical, but still significant, is the age of the accounts you have open and when the last activity on your accounts occurred. Lenders want to see stability, and if there are many recent account openings, your credit score will take a significant dip. The reports also reflect the mix of credit types, with revolving accounts such as credit cards weighing differently on the score than installment accounts like car payments.

Finally, the score will reflect recent attempts to secure credit. Each time a potential lender asks for a score at your request, it drops your score a bit. However, all inquiries during a short period for the same type of activity, such as a new auto loan, are treated as one request and won’t have a huge effect on your score.

In most cases, your credit score won’t include your payment history with utility or cell phone companies. Recently, credit bureau Experian began offering a service that adds your payment history on those types of bills into your credit score. Opting in to the program raises participants’ credit scores by an average of more than 10 points, according to the company.

How to Find and Fix Dings in Your Credit Report
The worst time to find out that you have bad credit or other credit issues is when you have fallen in love with a vehicle, and you’re trying to make the purchase. Many buyers have no clue about their credit until they are sitting in the dealership’s finance office, and that opens them up to accepting a lousy financing deal if they want (or need) to buy the car.

American consumers are entitled by law to one free copy of their credit report from Experian, TransUnion and Equifax each year. The law does not mandate that they provide your credit score, though your score is available for free from many credit card issuers and on lenders’ websites.

Well before you start your auto-buying odyssey, you’ll want to get copies of your credit reports and go over them in detail to identify any errors and negative information. Pulling your own copies of the reports each year does not affect your score like an inquiry from a lender does.

Errors can take time to get corrected, and you might need several months of making on-time payments on all of your accounts to raise your score appreciably. If you’re thinking of making multiple major purchases that require good credit, such as cars or a house, you’ll want to stagger them so that they don’t slam your credit score too badly by hitting your score at the same time. Though it might seem like a good idea, you shouldn't start closing credit cards in an attempt to raise your credit score. Doing so can potentially increase your credit utilization percentage and lower your score instead of building it.

If you do have to accept an auto loan deal without the best terms, know that you can usually refinance your car loan at any time during its term. You'll want to watch out for prepayment penalties, but beyond that, you may be able to save a tremendous amount of money if your credit score has improved before you refinance.

What Else Are Lenders Looking At?
There are several things on your credit report that are not reflected in your credit rating. Your age, income, marital status, address or employment don’t figure into your score, though your lender may ask for that information on your loan application and use it to the extent that it is legally allowed.

“You’re looking at that whole picture of the customer,” says Klepaski.

Beyond the information from your credit report, the lender will be evaluating your capacity to repay your loan: Do you have the cash flow to make your monthly payments? What is your monthly rent? They’ll want to know about your income, its sources and how stable your employment is.

“If you’ve had the same job for 10 years and you recently started another, that probably works,” says Klepaski. “If you’ve had 14 jobs this year that might be a red flag for somebody.”

From the information on your credit report and your auto loan application, the lender will compute your debt-to-income ratio. If you owe too much compared to your income, you’ll likely be asked to pay a higher interest rate, take a shorter loan, be required to make a more substantial down payment or accept a smaller loan. If the numbers are way out of whack, the lender can turn you down altogether.

The lender will also be considering the quality of your collateral. In the case of an auto loan, the secured collateral is the car that you need the money to buy. They will hold the title to the collateral until you pay off the loan.

Buyers asking for more than the cash value of a vehicle that they are buying may be asked to pay a higher interest rate or accept a shorter term than those making a substantial down payment. Why would the amount of financing be higher than the purchase price at the beginning of the loan? The most common reason is when buyers still owe money on their current car when they decide they need a new one. By rolling the balance of the old loan into the new loan, you create a loan-to-value (LTV) ratio that’s higher than 100%. Though it’s done all the time, it’s a foolish way to buy a car. It’s a better idea to wait until the balance of your current car loan is paid off to look for a new ride. If you find always having a new car to be important, you may want to consider leasing to get the latest technology and the ability to swap your vehicle every few years.

3) Find a Good Financing Deal

Different lenders charge auto loan interest rates depending on market demand, your creditworthiness, how much you’re borrowing compared to the vehicle’s value (the loan-to-value ratio) and their appetite for risk. The rates in the marketplace can vary substantially, depending on the lender. With a bit of research, it's easy to find competitive rates and promotional offers with generous terms.

Where Can You Get a Car Loan
Just like you should shop at several dealerships for a vehicle, you should shop with several lenders to find the best deal when you are financing a car. Never before have car buyers had the multitude of lending options and easy-to-access information about rates that they have today. Beyond getting loans from the financing arms of many carmakers, you can get auto financing from large national banks, small community banks, credit unions, finance companies and online-only banks.

Most Car dealers generally don't lend money themselves; instead, they act as agents for third-party lenders, such as banks, credit unions and finance companies. They’re compensated by the lenders for placing the loans. The financing that a dealer proposes may offer them the highest return, rather than giving you the best deal.

Large National Banks
Large national banks are the financial institutions that we all know by name. Examples include Bank of America, Wells Fargo, Capital One and Chase. They have thousands of physical branches in every corner of the country, smartphone apps and online portals. Their lending operations are sophisticated and they offer comprehensive online lending resources, but they may not be the best choice if you need personalized service or extra hand-holding through the loan process.

Community Banks
Community banks tend to have anywhere from one physical branch to a few dozen, spread across smaller geographic areas. They may not have all of the branches and services of national banks, but you may find it easier to talk with a local representative if you need a bit of help in getting a loan.

Online-Only Banks
Online-only banks don’t have physical branches, though many offer all of the services of large national banks. Ally Bank is an example of an online bank that works closely with auto dealers to make your car shopping and financing a one-stop experience.

Captive Finance Companies
Most automakers have financing arms, known as captive finance companies. While they provide traditional car loans, they’re also responsible for funding the carmaker’s special financing deals. You typically won’t find any other lender who will offer 0% interest or other rates that are well below the market average.

When cars aren’t selling as quickly as automakers would like them to, the manufacturers offer incentives to pick up the sales pace. Some of the most common are low- or no-interest financing deals, which can’t be matched by banks and other lenders. Getting a 0% auto loan means that you won’t pay a penny in interest over the life of the loan. You can see the best car financing offers on our new car deals and used car deals pages.

Credit Unions
Credit unions differ from other lenders. They are cooperatives owned by their members. Instead of providing profits to shareholders, nonprofit credit unions return their excess revenue to members in the form of lower interest rates on loans and higher rates on savings accounts. They range in size from tiny, one-person operations to massive institutions that rival the size of some national banks. The largest credit unions in the country are Navy Federal Credit Union, State Employees Credit Union, BECU (formerly Boeing Employees Credit Union) and PenFed Credit Union.

Not every credit union is open to every consumer. For example, only people with certain jobs can join Navy Federal or State Employees Credit Union. Almost anyone can join others, including BECU and PenFed. You can find credit unions that you are eligible to join at MyCreditUnion.gov. Before you get a credit union auto loan, you need to deposit a few dollars to become a member. Non-members are not eligible to get a loan from a credit union.

Financing Companies
Financing companies provide financing for various consumer purchases, including automobiles. While they loan money like other financial institutions, most don’t accept deposits. In many cases, finance companies offer specialized services to specific types of customers, such as those with subprime credit or those buying vehicles from their affiliated franchised new car dealerships.

Buy Here, Pay Here Dealerships
There is one class of auto dealers that does lend money directly to buyers. They're called Buy Here, Pay Here dealerships. Often the lender of last resort to desperate car buyers with bad credit, Buy Here, Pay Here dealers should be avoided at all costs due to their frequently exorbitant interest rates and draconian repossession tactics.

4) Apply for a Car Loan the Right Way

You should apply for a car loan from several lenders and pursue whichever offer gets you the best deal. It might take a bit of time and you'll have to provide your personal information to a number of lending institutions.

There’s nothing wrong with submitting multiple applications so long as you do so in a short period of time to avoid damaging your credit score. If you space your applications out over months, each application will knock your credit score down a few points. Do them over a short period, and the credit reporting agencies will see multiple applications as just one inquiry.

It's critical that you have an offer in place before you visit the dealer, though you may not need to use it. You'll want to do this a week or so ahead of visiting the dealership so that you can have a preapproved deal in your pocket before you actively start car shopping. If you time it right, any inquiries they make with credit bureaus won’t affect your credit score. If you don’t have a preapproved financing package, the dealer won’t have anything to try to beat, and you’ll be forced to settle for whatever car financing deal they offer. With a preapproval in place, you can avoid the pressure to accept a deal that's bad for your wallet.

When you fill out your loan applications, you will be asked for lots of information about your finances and employment history. You'll be asked for your Social Security number, as it is needed to pull a credit report. It is imperative that your answers and information are accurate and complete to avoid problems down the road. Not only can providing incomplete or untruthful information cause your loan application to be declined, but it can also be grounds for the lender to immediately place your loan into default status and demand full payment.

Can I Get a Car Loan if I’m Self-Employed?
Self-employed car buyers can get a car loan, though they’ll need to have more financial information to prove their creditworthiness than an employee with a typical salary or wage. Auto lenders will likely ask for detailed information about cash flow, the stability of their business and their assets. Since self-employed workers can’t show proof of employment and a steady paycheck, a lender may require them to make a larger down payment or agree to more costly loan terms.

What Do I Do if I’m Declined for a Car Loan?
Loan rejections happen all the time, though it can be surprising and frustrating when it happens to you. A denial means that a lending professional does not think that you are able to pay back the loan. In the long run, getting turned down can prevent you from getting in over your head on a bad loan. Be wary of a lender that promises that they will approve anyone, regardless of your credit. It's likely a lender who is willing to bury you in debt you can’t afford.

Loan rejections happen for many reasons, and the lender is legally required to tell you why you were declined. It may be your credit history, your job history or you might be asking for more money than your loan application indicates that you can pay back. If you were rejected due to an error in your report, you can probably fix it in a reasonably short time.

If you're asking for more than a lender thinks you can afford, rather than just seeking out another lender with looser standards, it’s a good idea to reassess what you’re asking for. Despite the promises they make in their advertising, it is critical you avoid the temptation to purchase from a “buy here pay here” car dealership. They can put you into a debt trap that you may never be able to escape.

Buyers with bad credit can qualify for loans, though you may be required to pay higher interest rates, pay more money as a down payment or accept a shorter loan. In some cases, you’ll learn that you’re simply looking at cars that are too expensive for your current budget.

If you’re rejected by an online lender or a large national bank, consider talking to a smaller credit union or community bank. There, you’re more likely to be able to tell your financial story to a real person. While they may not be able to give you the loan you were seeking, they can help you devise a plan to move forward and provide counseling along the way. Some lenders offer second-chance programs to help buyers with issues in their past find financing options and improve their credit picture.

Often, potential borrowers are declined because their credit history isn’t long enough for the lender to evaluate their creditworthiness. Getting a credit card and paying it off each month can help you build your credit history. You can also search for lenders who offer programs for first-time borrowers.