What Does Financing a Car Mean and How Does It Work

Financing a car means taking out a car loan that you repay over time or it means you are taking out a loan from a financial institution or vehicle dealership that you pay back at a given interest rate over time. When you take out a car loan, you agree to pay back the amount you borrowed, plus interest and any fees, within a set period of time. Shopping around and comparing loan offers could save you significant money in interest and fees.

Sometimes it seems like buying a car is a Catch-22 situation: You need money to buy a car but you need a car to get to work so you can earn money to buy one.

That’s why financing a car taking out a loan to pay for a car is common. You can think of a car loan as its own separate purchase it comes with a cost, which you pay through any interest and fees the lender may charge.

In this article, we’ll define what financing a car means, how it works, the smartest way to go about it, and whether vehicle financing is a good idea. The options for getting financing for a car along with any requirements will also be discussed. We’ve researched and compiled the top auto loan companies so you can compare vehicle financing options should you decide to get one.

Let’s take a look at how car financing works, how your credit can affect your loan terms and what to think about when trying to decide if financing a car is a good idea for you.

How Does Financing a Car Work?

“Financing a car” involves buying a vehicle with a loan rather than paying the full cost upfront. Over an agreed amount of time, you pay back the principal or the value of the car through monthly installments along with any fees and interest. Together the interest and fees you pay when financing a car make up the finance charge, which is the cost of taking out the loan.

The amount you pay monthly is determined by the value of your vehicle minus the money you put down, the given APR, and the loan term. Your APR makes up the interest payments and fees and is the main contributing factor to the price of your loan. Primarily your credit score influences the interest rate you get but other factors such as the age of the vehicle also help determine this.

If you plan to finance a car, you’ll need to shop and apply for a car loan. If you’re approved, you’ll make monthly payments until the loan is paid off. Each payment you make will be split into the following two parts: The principal payment, which goes toward paying back your loan balance
The interest payment, which pays interest due

Part of your payment may also go toward certain loan fees, like late payment fees.

Once you repay the loan in full, your lender will usually send a lien release document (depending on your state) to the state transportation agency. The car’s title will then be updated and transferred to you.

How Long Can You Finance a Car?

Terms for financing a car range from 12-94 months depending on whether you are financing a new or used vehicle. However, in most cases, the terms for most purchase loans for vehicles are around 72 months. It is also important to note that some lenders may not offer the longest and shortest-term options in this range.

Financing a car could be a way to take advantage of dealership incentives and car manufacturer specials, such as 0% financing or rebates. But keep in mind that you’ll typically need to get a car loan through the automaker’s finance company to qualify for these offers.

When you’re financing a car you can trade it in at any time to a dealer, but you still have to pay off the balance of the loan. Usually, the amount left over is covered by the trade-in value of the vehicle, but this depends on the age of the car and its condition among other factors.

If you need a set of wheels and don’t have the cash in hand to pay for it, financing may be your only option. Be sure to pay attention to how much you finance versus the value of the car you’re buying. If you don’t make a down payment and finance the entire cost of the car, you could find yourself owing more than your car is worth within a year or two.

Options for Financing a Car

Getting financing for a car is usually straightforward and can be done through various vehicle dealerships, online lenders, credit unions, and banks.

Each of these options fits into two different categories which include:Dealership Finance: Financing through a dealership involves signing a contract and getting a loan through their network of loan providers. It is often considered the easiest option and can save you money through their manufacturer car-buying programs. However, these often come with varying credit requirements and terms so you may be unable to take advantage.

Direct Lenders: This form of vehicle financing is done directly through banks, credit unions, and online lenders. Getting offers directly from loan providers allows you to compare offer terms and get preapproved. It can also give you leverage to negotiate when looking for a car at dealerships.What

Credit Score do you Need to Finance a Car?

There is no specific credit score needed to qualify for financing a vehicle, but some lenders have minimum requirements. While some loan providers may not have credit score requirements some may instead have income minimums. Each loan company has different ways of calculating whether you should get a loan and factors like income, credit, and vehicle type may be weighed differently in the process.

It’s generally a good idea to take some time to build your credit before applying for car financing — if you’re able to wait. If your credit scores are low, you may receive fewer offers than someone with good credit. And if you’re approved for a loan, you’ll likely get a higher interest rate than someone with a better credit score.

People with credit scores over 780 paid an average interest rate of 4.01% on their new-car loans, while those with credit scores of 500 or less paid an average rate of 14.3%, according to Experian’s report. This could translate to a major difference in how much interest you pay over the life of your loan.

Let’s say you got a five-year $20,000 car loan. Here’s how your credit could affect how much you pay in interest.

You’d pay more than $8,000 in interest on your loan with the 14.3% interest rate. That means your $20,000 vehicle would actually cost you more than $28,000.

Get Together The Required Paperwork

When financing a car there are four main requirements:

Proof of Identity: You will need to verify your identity with a government-issued ID which can include your passport, driver’s license, and birth certificate.

Proof of Income: In order to ensure you can make payments on time, documents like recent pay stubs, current bank statements, a recent W-2 form, or other statements. If you are self-employed, the last two years of your tax returns can also be used for proof of income.

Proof of Insurance: Like all auto loans or vehicle financing ventures you will need proof of the minimum required car insurance in your state. Getting this is typically easy, and you can call your car insurance company to get a binder to show you have the proper coverage.

Proof of Residence: To show proof of residence, you may provide your driver’s license, utility bill statements, insurance bills, mortgage or lease statements, and bank or credit card statements.

In some situations, you may need additional information such as your social security number or vehicle purchase documents in order to finance a car. If you are financing a used car you’ll need the original title document before you can move forward with an auto loan.

Get Rates From Auto Lenders

Lenders may not offer the same APRs and loan terms when you’re financing a car, so compare rates from auto loan providers. There are plenty of vehicle financing options, from dealerships and banks to companies that specialize in auto loans.

When getting quotes from auto loan providers you must know the differences between being prequalified and preapproved when financing a car. Prequalification offers an estimate of your rate, but because potential lenders only do a soft credit check, the rate could change after you apply for a loan. Preapproval comes after a hard credit check and almost guarantees financing at the terms outlined in the preapproval offer.

Preapproval can lead to a slight decrease in your credit score, but it allows a serious shopper to calculate the monthly car payments for the life of the loan. FICO counts all hard credit checks relating to your car loan as a single inquiry for up to 45 days, so rate shopping won’t impact your credit more than once.

Pick The Best Auto Lender For You

Everyone has different needs when it comes to financing a car. While some may avoid auto lenders with higher interest rates, others would be satisfied with any provider that’s willing to finance their vehicle.

When choosing an auto lender, keep the following factors in mind:APR: The lower the APR listed in your contract’s disclosures, the less you’ll pay to borrow money.

Term length: Your loan term can vary considerably in length. Having a long-term loan typically means you’ll pay less per month but more over the full amount of time.

Down payment: Making a significant down payment can save you money on interest when financing a car. The minimum down payment–if any–is determined by each auto lender. You may be able to use the trade-in value of your old vehicle toward the down payment on a new vehicle.

Tips for Financing a Car

Below are some tips to keep in mind if you decide to finance a car through a purchase loan:Get preapproved: Getting preapproval for an auto loan gives you leverage and a better understanding of what you can afford. What you are offered helps you find out what to rates and terms to expect from a dealer and gives you perspective on what is a good deal for your financial situation.

Put down a sizable down payment: Conventional wisdom suggests that putting down at least 20% of the vehicle’s value is a good idea. The higher your down payment is, the lower your monthly payments and interest rates will be.

Don’t buy vehicle add-ons immediately: Dealerships will try to sell you a number of things including gap insurance and extended warranties at extremely high prices. While these can be good investments, there is no need to buy them as soon as you get a loan and it is better to take your time and compare options.

Get a shorter loan term: If you can afford it, getting financing a car with a shorter loan term length allows you to have lower rates and pay less in the long term.

Finance a car you can afford: Generally it is recommended by financial experts to not pay more than 10-15% of your take home pay on car payments. Also, considering purchasing a used car can save you a lot of money as well.

Just as you might shop around for a car, you’ll want to shop around for a car loan. The interest rate and loan term you’re offered may vary by lender — shopping around could help you find the best rate and terms for your budget.

Applying for prequalification with different lenders and getting prequalified can help you see estimated loan rates and terms without a hard inquiry appearing on your credit reports. But remember that getting prequalified isn’t a guarantee of loan approval — your loan terms may change after you submit your loan application and the lender runs a hard credit inquiry.

As you consider each loan offer, don’t just focus on your monthly payment. Look at the total cost of financing, too. For example, it may be tempting to choose a longer loan term to lower your car payments, but you could end up paying much more in interest over the life of the loan. Finding the best financing for your needs can take some strategy and time. But in return, you could save hundreds or even thousands of dollars.


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