Buying a car can be a frustrating thing: You need money to buy a car, but you also need a car to get to work so you can earn money to buy a car. Your only option is to finance a car.
It can feel like a no win situation.
But what does it mean to finance a car?
According to statistics, Americans owe more than $1.2 trillion in auto loan debt. And Americans take out about $51 billion in 2.3 million new auto loans each month.
So as you can see, borrowing money to buy a car is necessary for most people.
Think of a car loan as its own separate purchase, the cost of which you pay with any interest and fees that the lender will charge.
WHAT DOES IT MEAN TO FINANCE A CAR?
How does car financing work?
Let’s take a look at how car financing works, and how your credit can affect your loan terms. It’s best to have this information before you’re ready to actually buy the car.
Let’s also look at what you should consider when deciding if financing a car is a good idea for you.
Financing a car means you’re borrowing money from a bank or financial institution. This money will allow you to purchase the car from a dealership or private party.
For some, financing a car can mean committing to a large monthly payment. Not everyone is okay with this, but others are fine with it.
When you finance a car, a bank or other financial institution lends you the money. In exchange, you pay the lender interest and possibly other fees to borrow that money over a specific number of months.
Car Financing Options
The types of companies that can finance your car include banks, credit unions, online lenders and finance companies. Some some car dealerships can also finance your new car purchase.
Financing through a credit union or bank might be less expensive than getting a loan through a dealership. This is because dealers have been known to have higher interest rates as payment for arranging your financing.
When dealerships provide their own financing, this is called “in-house” financing, or “buy-here, pay-here” dealerships.
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 the agreed upon interest due
Part of your payment can also go toward certain loan fees, like late payment fees when they apply.
Your monthly payment is determined by the amount of your loan (the car’s purchase price minus any down payment and trade-in), annual percentage rate, or APR, and loan term.
The APR is one of the biggest factors to consider. It affects how much money you’ll end up paying for the car. Different factors can affect your interest rate, including your credit rating, loan term and whether you’re buying a new or used car.
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.
Most of us don’t have huge chunks of cash laying around to buy a new car outright, so we apply for a loan at a bank or financial institution to pay for the car.
Then, based on your credit history and income, the bank will set an interest rate so you’ll make monthly payments for the next 3 to 5 years. Sometimes longer.
The repayment time frame is up to you. I chose three years when I bought my last car. Statistics also show us that the average car loan term is 69 months for new cars, 35 months for used and 37 months for leased vehicles.
Something you should ask about, is whether there’s an early repayment penalty, in case you want to pay off the car early.
If you’re making payments on a vehicle, it means the car belongs to the bank, not you. Until you pay off the loan and receive a “pink slip,” also known as the title of the car, you don’t actually own the car.
If you’re still financing a car and decide to sell it, make sure the balance of what you owe the lender is covered in the sale price of the car.
How good does should your credit be to finance a car?
There isn’t a universal minimum credit score you should have in order to finance a car.
Each lender sets their own minimum credit scores, and weighs factors like the type of car you’re buying and your income differently.
Some lenders are even willing to work with people who have bankruptcies or recent repossessions in their credit history.
Still, the average credit score was 718 for new-car loans and 662 for used-car loans in the third quarter of 2019, according to Experian’s State of the Automotive Finance Market report.
The report also shows that only 38% of all car loans were made to people with credit scores below 660.
How Much Should You Have for Your Down Payment?
When you finance a car, you typically need a cash down payment. The higher the down payment amount, the lower the monthly payment, same concept as a when you purchase a house.
Most lenders recommend that you put down at least 10 percent or more of the vehicle’s sale price, so if the car you’re interested in costs $25,000, you should put down at least $2,500.
Tax and license can cost you another few thousand dollars, depending on the cost of the vehicle and the state you live in. If you don’t pay for this, you can roll it into your monthly payments. But this will increase the price of the car.
How to Estimate Your Monthly Payments
Let’s say the car you want to purchase is $25,000. You have $2,500 for a down payment, qualify for a 3 percent interest rate, and decide to go with a 5-year loan (or 60 months). We’ll assume you were able to pay the full amount of tax and license fees.
Your monthly payments will be about $404 a month.
You can play with the numbers on a Cars.com calculator.
Dealerships sometimes offer a zero down payment option for certain cars. If you choose this route, expect that your monthly payments will be higher. If we use the same example from above and don’t shell out any money up front, your monthly payment will be about $449.
Shopping Around and Hard Credit Pulls
When the time comes to finance your car, you don’t need to go with the bank that the dealership partners with.
A few of the car dealers will encourage you to go with the bank they use even though the interest rate is probably higher than what you’ll be quoted elsewhere. Their reasoning will be that “it’s an easier transaction” when you choose their lender.
But that’s not necessarily true.
Regardless of where you get your financing, they’ll need to pull your credit. But, you don’t need to worry about your credit being pulled multiple times, which can result in lowering your score.
If you’re shopping around for a car, it will only appear as a hard pull once on your credit, even though multiple lenders are pulling your score.
The only thing you need to be aware of is the timeframe in which various lenders are pulling your credit. This ranges anywhere from 14 to 30 days. As long as inquiries are made within this period, it will only count as one hard pull.
This rule also applies to people who are shopping around for a home and need to get their credit pulled from multiple lenders.
If you’re shopping for a car and your credit isn’t where you’d like it to be, if you have a credit score that’s in the 550-620 range, think about doing the work to increase it to the high 600s or low 700s before shopping for a vehicle. That way, you’ll probably qualify for lower interest rates from lenders. This means that you put out less money over the life of the loan.
Should You Get Pre-Approved?
Rates fluctuate frequently, so for this reason, it makes good sense for you to get pre-approved from a bank. This pre-approval status locks in your interest rate and shows the dealer that you’re serious about buying.
Until you can get pre-approved, banks can only give you a quote, which is just an estimate of how much you’d qualify for.
Which Lender to Choose
When you shop around for interest rates, look at the numbers, but also consider the bank it comes from.
While this doesn’t seem all that important, it really does matter. You will be dealing with this company for the next handful of years, so make sure that you like what you see.
New vs. Used Vehicles and Interest Rates
Some dealerships have enticing offers for new cars, like zero percent financing for the life of the loan. This was the kind of deal that I got with my last car. It saved me a ton of cash over the life of the loan.
Is Financing Your Only Option for Buying a Car?
In a perfect world, we’d all have enough cash to pay for our new cars without putting a big dent in our savings.
It’s a trade-off. Weigh the pros and cons in order to make the most informed decision that makes sense with your finances.