How to Finance a Car: A Step-By-Step Guide
Most car buyers put all of their efforts into finding the perfect car. While that’s critically important, figuring out how to pay for it and getting a car loan are also vital parts of the car-buying process. Figuring out your budget and financing can also help you gauge how much vehicle you can afford, helping you narrow your choices. Few buyers can afford to pay cash for the full price of new- or used-car purchases. Instead, you’ll need to get an auto loan to cover either the entire cost of the vehicle or a substantial part of it. Getting a bad car finance deal can mess with your wallet and wreck your credit history for years.
“Do your homework, and make sure it’s not just about ‘hey, I want to pay $300 a month,’” says Erin Klepaski, executive director of strategic alliances at Ally Financial. “Really make sure that vehicle meets your needs – that you can insure it, that the fuel economy makes sense for you, you can drive the number of miles 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 shopping the vehicle payment.”
Our new car rankings and used car rankings and reviews will help you find the right vehicle, while the following steps will guide you through getting a great deal on your car loan.
It is common for car buyers to put off the thought of financing until they are in the dealership’s financing office. That’s, unfortunately, a path to potential financial calamity. Smart car buyers know precisely how much vehicle they can afford and have a plan in place to finance their new ride before they even think about heading to a dealership. While you might end up with dealer financing, if the dealer doesn’t have an offer to beat, they’ll have no incentive to give you a deal.
Here’s an outline of everything you need to know about car financing before visiting the dealer:
- Learn The Language of Lending – Know all the finance terms that are likely to be discussed during your visit.
- Your Credit Score, and Why it Matters – Understand what your credit score is and why it matters for financing your car.
- Finding a Good Financing Deal – Learn where and how to get car financing that you can afford.
- Applying for a Car Loan – Learn the steps to apply for a car loan.
- See What Financing the Dealership Offers – Compare your pre-approved auto loan to the offer from the dealership.
- Finalizing the Deal – Sign on the dotted line and close the deal.
- After You Have Signed the Loan Documents – Know what happens after you finalize the deal.
Learn the Language of Lending
There are some essential terms that you’ll want to understand before you enter the financing world. Here are a few of the most important:
Car Loan (also auto loan, car financing): A car loan is simply 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 zero percent financing deal, you’ll have to pay interest each month on the loan balance. Some lenders will also charge you a loan fee.
Until you completely pay off the loan, the lender will hold the title to the vehicle.
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, risks, and provides them with a profit margin.
For the last several years, auto loan rates have been near historic lows, though they are slowly climbing toward a more normal range. The annual percentage rate you’ll pay is affected by a multitude of factors, including many you can control and some 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 are likely to charge significantly different interest rates for the same vehicle purchase.
Car Loan Term: The loan term is the length of the 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 months or more are widely available. It helps to divide the loan term by 12 so that you understand 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 so that you can avoid the possibility that you’ll still be trying to pay off your car at the same time as the car’s age is leading to 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’ll 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 car 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.
Your Credit Score, and Why It Matters
You actually have several credit scores, as different credit reporting companies use different methods to determine scores. The main three credit bureaus are Experian, TransUnion, and Equifax. Sometimes your credit score will be referred to as your credit rating or FICO score. A FICO score is just one type of credit score available to lenders. While most models range from 300 to 850 points, 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 easier 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. Typically, if you have steady employment and a score of 720 or above on most scales, you should not have any problem getting financing.
So, 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 obligations. The more often you have been late, the more points that 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 percent of the credit that you have available, for example, it will hurt your credit score more than if you’re just using just 30 percent of your available credit. If you are considering closing credit cards, you should 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.
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.