What Does It Mean to Finance a Car
When you finance a car, you take out an auto loan and borrow money to cover some or all of the purchase price, plus fees. You pay interest on the money you borrow—but this is generally considered a good tradeoff.
Without an auto loan, you need to pay cash upfront when buying a car and this may limit your options to cheaper, older vehicles. Read on to find out everything you need to know about how to finance a car!
How Do Auto Loans Work?
An auto loan is a convenient way to finance a new or used vehicle. The amount you need to borrow will depend on the purchase price of your vehicle and the size of your down payment.
- An auto loan is a type of installment loan so you make equal monthly payments until the loan is paid off in full.
- This is different from a credit card, where your monthly payments go up and down depending on your purchases.
- Your auto loan payments include interest, which means you pay extra in return for borrowing the money.
- The annual percentage rate (APR) may include interest plus other fees rolled into one handy figure.
- You can choose your auto loan term, or how long it takes to pay the money back.
- Shorter loan terms often get lower rates.
- Newer vehicles often get lower rates.
What Credit Score Do You Need to Get an Auto Loan?
The credit score you need to qualify for your auto loan may depend on your lender and your overall financial situation. Your credit score also impacts what rate you get—higher scores get lower rates.
- You may need a score of 720 or better to qualify with no down payment and to get a great rate.
- You may need a score of 660 or over to qualify with no down payment and to get a good rate
- To get an auto loan with lower credit scores, you may need a down payment and you might get a slightly higher rate.
8 Steps to Get an Auto Loan
Maybe you're still wondering, What does it mean to finance a car? So here's a simple step-by-step guide on how to secure an auto loan and buy your next vehicle:
- Choose a financial institution that offers auto loans—your local credit union may offer better rates than online lenders.
- Apply online with your personal and financial details and any information you have about the vehicle you plan to buy, such as the purchase price and year.
- You can get your auto loan pre-approved with multiple lenders—they’ll review your credit history and offer you a rate for your preferred loan term and vehicle.
- Once you have your pre-approval, head to the dealership or search online for your vehicle.
- Give your lender the confirmed details about your vehicle so you can sign the final auto loan contract.
- Your lender will transfer the funds or write you a check to complete the purchase.
- You begin making monthly payments on your auto loan and continue until it's paid off in full.
- When your auto loan is paid off, you own your car outright!
Note that your credit score will drop temporarily when you apply for your auto loan, but then it will recover and improve when you start making timely monthly payments. Multiple auto loan applications within two weeks count as one credit check only!
Factors to Consider When Choosing an Auto Loan
Make sure you choose an auto loan lender and loan amount that you can comfortably afford so you don't find yourself under financial pressure and you're not at risk of losing your car.
Loan Amount
First, determine how much monthly payment you can afford. Then look at the purchase price. Your lender may limit the amount you can borrow so you need to shop within that price range.
The more you borrow, the higher your monthly payments will be and the longer it will take you to pay off your loan. You'll also pay more total interest.
APR
Borrowers with better credit scores and higher down payments will typically get lower interest rates. The lower your rate, the lower your monthly payments, and the lower your total cost of borrowing.
Loan Term
The loan term has a significant impact on your auto loan. Typical auto loan terms are between 24 and 84 months.
A shorter loan term may result in higher monthly payments, but you get a better rate and pay less total interest. A longer loan term means lower monthly payments, but a higher interest rate and higher total borrowing cost.
On the other hand, longer loan terms will increase your debt-to-income (DTI) ratio less than shorter loan terms—and it's a good idea to keep your DTI as low as possible.
GAP Insurance
As you drive your car, it will lose value (or depreciate) and that's why many car loans come with GAP insurance. Make sure you choose a lender offering a great GAP insurance rate.
In the event of an accident where your car is totaled, GAP Insurance covers the difference between your vehicle’s current value, the amount your insurance pays, and the amount you still owe on your auto loan.
Tips for Responsible Car Financing
An auto loan is secured by your vehicle so if you miss payments, your lender can seize your car. What’s more, your credit will also take a hit.
Here's what to do to make sure you have a great auto loan experience:
- Consider your finances—how much room do you have in your budget?
- Request your credit report and, if needed, spend some time improving your score before applying for your auto financing.
- Choose a loan term as short as you can afford to minimize interest.
- Be sure to make all your payments on time to avoid hurting your credit score.
- Read the terms and conditions and avoid lenders that charge prepayment fees for paying off your loan early.
- If you’re planning on buying a home at some point, be careful to keep your debt-to-income (DTI) ratio below 43%.
Next Steps: Calculate an Affordable Car Payment
When choosing an auto loan, talk to your lender about how to finance a car in a way that will best fit your situation. Your lender can help you determine the best purchase price and loan term so you get a car payment that fits your budget.
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