How Does Financing a Car Work?
Most people can’t pay cash for a car, so car financing is a must-have for most car buyers. Financing your car means borrowing money to pay for the car and then paying back the loan over time, with extra money called interest. When the load is paid off, you will own the car outright.
If you’re shopping for a new vehicle, you may be wondering, “How does financing a car work?” With so much money on the line, you want to be well-informed so you can get the best auto loan for your needs. Here are some of the top things you need to know about how to find and choose the auto financing that works for you.
Understanding car financing
When you finance a car, you take out a loan from a bank, credit union, or other lender to purchase the vehicle. The lender then gives you the money to pay for the car, and you agree to pay them back over time, plus interest and fees.
The amount of interest you pay will depend on your credit score and the terms of the loan. A higher credit score will usually qualify you for a lower interest rate. The loan term is the amount of time you have to pay back the loan, and it is typically between 24 and 72 months.
To finance a car, you will typically need to provide the lender with the following information:
- Your name, address, and Social Security number
- Your income and employment information
- The type of car you are planning to buy
- The purchase price of the car
Once you have been approved for a loan, you will need to sign a loan agreement. This document will outline the terms of the loan, including the interest rate, loan term, and monthly payments.
- You decide to buy a car for $20,000.
- You get pre-approved for a car loan for $20,000 at a 5% interest rate for a 60-month term.
- You go to the dealership and buy the car.
- The dealership finances the car through the lender.
- You start making monthly payments of $377.42 to the lender.
- After 60 months, you have paid off the loan and you own the car outright.
You will then make monthly payments to the lender until the loan is paid off. Once the loan is paid off, you will own the car outright.
What steps do I need to take to finance a car?
You can finance a car purchase by applying for an auto loan and getting approved by the lender. You can use the car dealer’s in-house financing or find your own through banks, credit unions and online lenders. Follow these steps to find the car loan that is right for you.
Determine your needs
Choose the car you want to buy and determine roughly how much it will cost. Use an auto loan calculator to assess your budget and figure out how much car you can afford. Do you have money for a down payment? That means you will pay some money up front so you finance a smaller amount. A smaller loan amount will reduce your monthly payment and the amount of interest you pay compared to financing 100% of the car.
Check your credit score
Check your credit score to better understand the types of interest rates you may expect. Some loan calculators let you input your credit score to see how it affects the interest rate of your loan. Your bank or credit union may offer a free look at your credit score.
Get preapproved
Before visiting a dealership, apply for a loan with a bank or credit union to get preapproved for financing up to a specified amount. Your preapproval offer will also tell you the interest rate and loan term — the number of months it will take to repay the loan and interest. Getting preapproved can give you more leverage during negotiations and help you avoid upsells and dealer markups.
Ask the dealer to beat your preapproved rate
Take your preapproval offer with you to the car dealer and ask if they can offer a better rate. If they can’t, you can feel confident that your preapproval offer is a good deal. When comparing offers, be sure to consider the total cost to borrow, including total interest and fees.
Finalize the deal
Depending on the offer details, you can either accept the financing the dealer offers or you can use the preapproval lender. To finalize the deal, you’ll sign the loan and car ownership documents, submit your down payment and finalize any trade-in details.
Your first car payment is usually due 30 to 45 days from the day you complete the paperwork. You may be asked whether you want to sign up to make automatic loan payment withdrawals from your bank account; many lenders offer autopay discounts.
Make sure you understand all the loan terms and confirm that they match what you agreed to with the dealer or lender.
You will also have to show proof of auto insurance before the deal can be finalized. The requirements for insurance will vary by state and lender. Some lenders may require full coverage, even though the state may only require liability insurance. Once all the paperwork is done, you can drive away in your new-to-you car.
What credit score do I need to finance a car?
Your credit score is a three-digit number that represents your financial history, based on factors like the amount of debt you have, how long you’ve had open credit and whether you’ve been late on payments. A higher score will increase the chance your loan application will be approved, and you may be eligible for lower interest rates.
There’s no set minimum needed to apply for an auto loan, but a score of 660 or above will open the door to reasonable interest rates. There are several different types of credit scores, so you may see different numbers from different sources.
You can check your credit score for free with LendingTree, and if it’s lower than you’d like, you can work on improving your score before applying for car financing. You can also get free copies of your credit reports from AnnualCreditReport.com to see if there are any errors that could be dragging down your score.
In general, the higher your credit score, the better your chances of being approved for a low APR on your auto loan. Here are average APRs as reported by Experian, broken down by credit band.
| Credit score | Average APR for new cars | Average APR for used cars |
|---|---|---|
| 780-850 | 5.61% | 7.43% |
| 661-780 | 6.88% | 9.33% |
| 601-660 | 9.29% | 13.53% |
| 501-600 | 11.86% | 18.39% |
| 300-500 | 14.17% | 21.18% |
Source: Experian State of the Automotive Finance Market, Q3 2023
Where can I find auto financing?
Most people need to get an auto loan to buy a car. Dealers offer financing or you can shop around on your own with banks, credit unions or online lenders. You don’t have to use the dealer’s in-house financing, though they may offer incentives like a lower purchase price or 0% interest on a new car. With LendingTree, you can get up to five auto loan offers from lenders without impacting your credit score.
Banks or credit unions
Banks and credit unions offer auto financing for new and used cars, and you get prequalified on your own. Some banks like Bank of America and credit unions like Navy Federal Credit Union also offer financing through dealers, which may have different terms than what you get directly. Credit unions usually require you to be a member to get a loan, but the requirements are often easy to meet.
Start your search with your current bank or credit union, which may give you a rate discount for setting up automatic payments from your checking or savings accounts.
Captive lenders
Auto manufacturers have their own financing companies, called captive lenders, for their dealers to use. Captive lenders are often the only way to get incentive financing, such as a 0% APR on auto loans.
In some cases, the captive lender is owned by the auto company, such as Ford Credit. In other cases, the captive lender is a separate finance company that works with the dealer, such as Subaru Motors Finance (SMF) that uses Chase Bank. Dealers also work with other lenders for new and used car loans, such as Ally Bank.
Online lenders
Online lenders may also make auto loans directly. With lenders like LightStream, the entire application process is completed online. Thanks to lower overhead costs, online lenders sometimes have the lowest interest rates on the market.
How do I know which loan offer is best?
A loan offer will include the annual percentage rate (APR), term or length of the loan and the total loan amount. The APR includes the interest on the loan plus any additional fees. When comparing loans, look at the APR, the total amount financed, and the total amount you will pay over the life of the loan. Also look at any potential fees, such as whether there is a prepayment penalty for repaying the loan early.
You don’t have to accept the dealer or lender’s first loan offer. You can negotiate the APR, length of the loan, and dealer fees that may be rolled into the loan amount, though there is no guarantee that the lender will budge. You can also negotiate the purchase price of the car and the value of a trade-in vehicle.
Don’t focus on monthly payment alone; compare the total amount you will pay over the life of the loan. The lender may offer a longer loan term that would lower your monthly payment, but you’ll end up paying more in interest with a longer loan. In the example below, your monthly payment would be almost $85 less each month with a longer term, but you’ll end up paying an additional $1,500 over the life of the loan.
| 5 years (60 months) | 6 years (72 months) |
|
|---|---|---|
| Amount financed | $31,000 | $31,000 |
| APR | 8.52% | 8.52% |
| Monthly payment | $636.31 | $551.44 |
| Total of payments | $38,178.68 | $39,703.33 |
Frequently asked questions
You will pay more than the cost of the car due to interest and fees on the auto loan. If you don’t make payments, the car could be repossessed.
Lenders will have to run a hard credit inquiry to make a loan decision, which can temporarily cause your credit score to drop by a few points. If you make multiple loan applications within a 14-day rate shopping window, it won’t hurt your credit score any more than a single inquiry. If you make your loan payments in full and on time, the positive payment history can eventually help your credit score.
Traditionally, down payments on a new car have been 10% to 20% of the purchase price. If you have a trade-in, that can serve as your down payment if you have positive equity in the vehicle. A down payment will reduce the amount you have to borrow, which will reduce your monthly payment.