Financing a Car: A Comprehensive Overview

Financing a car can be a complex and overwhelming process, but understanding the basics can make it more manageable. You can get a car loan from a bank, credit union, or online lender.

The average interest rate on a car loan is around 4-6% APR, but this can vary depending on your credit score and loan terms. Some lenders may offer lower rates to attract more customers.

Before applying for a car loan, it's essential to check your credit score to get an idea of the interest rate you'll qualify for. A good credit score can help you secure a lower interest rate and better loan terms.

You can expect to pay around 15-20% of the car's purchase price as a down payment, although some lenders may require more or less.

Additional reading: Financing a Car with 600 Credit Score

Armed with your pre-approval, you're now ready to visit multiple dealerships and test-drive as many cars as you want before making a decision to buy.

You can use your pre-approval as a bargaining tool during negotiations with the dealer, especially if the dealer is asking more than your pre-approved amount.

Consider using that gap as leverage to get a better price, like trading in a lower purchase price for a new car or free vehicle add-ons.

Capital One, for example, has specific restrictions for financing a used car, capping the maximum amount you can borrow and the age and mileage of the car.

You can only finance a used vehicle that is no more than 10 years old and has 120,000 miles or less on its odometer with Capital One.

Related reading: Financing Used Car from Dealer

When you're buying a car, it's essential to consider your financing options carefully. Shopping around for an auto loan can be time-consuming, but it can also save you money by giving you a chance to compare interest rates.

If you're willing to put in the effort, you can potentially secure a better deal by working directly with a bank, credit union, or online lender. Securing financing ahead of time also means you know how much your loan will cost.

Expand your knowledge: Car Loans for First Time Car Buyers

You don't have time or inclination to shop for a loan? No problem. Dealer-arranged financing can be more convenient and may even cost less.

Having poor credit can make it difficult to get a loan from a bank, but dealerships may offer financing options that banks don't. If your credit is good enough, you may even qualify for a dealer's promotional offers.

Here's a summary of the key differences between financing through a bank and a dealership:

Before you start shopping for a car, it's essential to prepare yourself financially. Review your credit report and credit score to understand your financial situation. You can check your Experian credit report and FICO Score for free.

To get the best auto financing, work to improve your credit score if necessary. Late payments, high credit card debt, and new credit applications can negatively impact your credit score. According to Experian data, buyers with excellent credit can get new car loans with an average APR of 5.05%, while those with very poor credit pay an average APR of 15.43%.

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Research the car you want to buy and calculate the costs of ownership. This includes insurance, monthly maintenance, and fuel expenses. The average new car loan payment was $737 per month, while the average used car loan payment was $520 per month, as of Q3 2024.

Save for a down payment of at least 10% to 20% of the vehicle price. This reduces the amount you need to borrow and the interest you'll pay over the life of the loan. A bigger down payment also reduces the risk of owing more than the car is worth.

To finance a car, you can apply for an auto loan and get 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.

Here's a summary of the steps to buy a car:

By following these steps, you'll be well-prepared to buy a car and get the best financing options available.

When buying a car, it's essential to understand the insurance requirements that lenders often impose on borrowers. Lenders typically require borrowers to have a full coverage car insurance policy throughout the loan term.

Full coverage policies are more expensive than minimum coverage policies, which only provide the minimum amount of required coverage in your state. This means you'll need to budget extra for a full coverage policy.

To mitigate risk, lenders require borrowers to have a full coverage car insurance policy that includes collision and comprehensive coverage. These policies pay for your vehicle's repairs if you cause an accident.

Lenders want to ensure that borrowers can cover the costs of repairs if they're involved in an accident.

A different take: Do You Need Full Coverage When Financing a Car

You have several options when it comes to financing a car. Banks and credit unions offer auto financing for new and used cars, and you can 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.

You can also consider online lenders, which may offer the lowest interest rates on the market. With online lenders like LightStream, the entire application process is completed online, making it a convenient option.

If you're shopping for a new car, you may be offered different types of financing at the dealership. The dealer may offer dealer-arranged financing, captive financing, or buy here, pay here (BHPH) financing. Dealer-arranged financing works like bank financing, except the dealer acts as a middleman to find a lender for you.

Here are some types of financing you may encounter at the dealership:

You can also consider financing through the dealer if you're shopping for a certified pre-owned vehicle. The brand's captive lender may be running financing and leasing deals on the vehicle you want to buy. However, be aware that financing through the dealer can restrict your ability to shop around for a better interest rate.

For more insights, see: Car Financing Companies for Car Dealers

The average amount borrowed to buy a new vehicle reached just over $40,200 in the second quarter of 2022, up about $5,000 since a year ago.

Interest rates, too, increased to 5.97% for a 60-month loan on a new vehicle as of November 2022. This means that if you finance $40,200 for 60 months at 5.97% interest, you will pay $777 per month.

Knocking just one point off that interest rate to 4.97% reduces the monthly payment to $758. The total interest paid over those five years drops to $5,284, saving you $1,113.

The annual percentage rate (APR) is essentially the cost of borrowing money. Your credit score determines your creditworthiness, which in turn affects the APR assigned by the lender.

A higher credit score will usually qualify you for a lower interest rate. For instance, if you have poor credit, the lender might consider you more likely to default on your loan and set a higher APR.

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To qualify for a lower interest rate, you need to have at least a good credit score. You can use auto loan calculators to get an estimate of your monthly payments, factoring in interest on top of the vehicle price.

Here are some typical loan terms and their corresponding interest rates:

Keep in mind that a longer loan term allows you to pay off the car slowly, but it also means you'll pay more interest. If you can afford to spend more on your monthly car payment, consider opting for a shorter loan term.

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Leasing is a financing option where you essentially rent a car for a set period, usually 24 to 36 months, with the lender owning the vehicle at the end of the lease.

The monthly payment for a lease is based on the lender's projection of the car's value at the end of the lease, with the difference in value being the basis for the payment.

Leasing can be a good option if you want a lower monthly payment, as it's often less than a traditional car loan.

However, at the end of the lease, the car still belongs to the lender, and you won't have any equity in the vehicle.

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Leasing is a long-term rental, where you never own the car, and at the end of the lease, the car still belongs to the lender.

The leasing share of retail new vehicle sales is projected to be 19% in 2022, according to Cox Automotive.

Lease terms are usually 24 to 36 months, but they can be shorter or longer.

Monthly payments for a lease are based on what the lender believes the car will be worth at the end of the lease.

The monthly payment for a lease is almost always less than the monthly payment for a traditional car loan.

Calculating the interest, or "money factor" in leasing, gets based on the purchase price.

At the end of a lease, you don't share in the car's equity, or have anything tangible to show for those monthly payments.

Broaden your view: What's the Difference in Leasing and Financing a Car

If you're considering a lease, it's worth noting that with a financed car, you'll eventually own the car outright. You can choose to keep the car for years or sell it and use the money to buy your next vehicle.

With a financed car, you'll have the freedom to decide what to do with the car after you've paid off the loan. This can be a big advantage over leasing, where you'll typically need to return the car to the dealer at the end of the lease.

You'll have the option to keep the car for as long as you want, or sell it and use the money to upgrade to a new vehicle. This can be a great way to build equity in a car and have more control over your transportation options.

Review your finances to establish how much you can afford to put toward a down payment and your maximum monthly payment. Most lenders' websites have auto loan calculators to estimate your monthly payments, factoring in interest on top of the vehicle price.

You can stretch your budget by opting for a longer loan term, but this will likely result in a higher loan rate. A 72-month loan term can reduce your monthly payments, but be aware of the potential consequences.

Related reading: Car Financing No down Payment

It's essential to understand the maximum amount you're able to borrow, and that's where pre-qualification and pre-approval come into play. However, you shouldn't plan to put the entire principal of a loan toward the vehicle price, as you'll also need to pay taxes and other fees on your purchase.

Auto-buying site Edmunds suggests reserving several thousand dollars of the loan amount to cover extra expenses, such as taxes and fees. This will help you avoid overspending and ensure you have enough money for other costs associated with buying a car.

Consider your down payment options, as financing a smaller loan amount will reduce your monthly payment and the amount of interest you pay.

To get a car loan, you'll need to submit some documents, including tax returns, pay stubs, and bank statements. This is part of the pre-approval process.

A formal credit check is required for pre-approval, which will show up on your credit history as a hard pull. This can lower your credit score by a few points.

You'll need some form of identification, but a driver's license is usually not necessary. However, it's always a good idea to have it with you.

A preapproval letter from a lender will include your loan terms, such as the interest rate and loan period. This can help you negotiate better loan terms with a different lender.

Getting preapproved can also give you more leverage during negotiations at the dealership.

Managing your loan responsibly is crucial to avoid financial stress. Review your loan terms to understand the interest rate, repayment period, and any fees associated with the loan.

To avoid late payments, make sure to set up a payment schedule and stick to it. If you're going to be late in a particular month, contact the lender in advance to explain the reason for the delay.

By taking these steps, you can manage your loan effectively and enjoy the benefits of owning a car without financial burden.

Building equity in your loan can be a smart financial move. At a certain point during the loan term, you'll own a bigger percentage of the car's value than what you still owe.

This means you can sell the car and use the equity to pay off the loan or put it towards a down payment on a new car. Financing a car allows you to build equity over time.

You'll eventually own a bigger percentage of the car's value than what you still owe.

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Managing your loan responsibly is key to avoiding financial stress. You should make car payments on time to avoid late fees and damage to your credit score.

Missing a payment can have serious consequences, so it's essential to prioritize your loan payments. If you're going to be late in a particular month, contact the lender in advance to explain the reason.

Building equity in your car is a great benefit of financing, but it's not the same as owning the car outright. You'll still owe money on the loan, but you'll own a bigger percentage of the car's value over time.

Unless you're a member of the 0.01%, you'll likely need to finance a part of your car purchase. Cash is always the best option, but if you can't pay cash, a car loan is a viable alternative.

When comparing loan offers, look at the annual percentage rate (APR), term, and total loan amount. The APR includes interest on the loan plus any additional fees.

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.

A longer loan term may lower your monthly payment, but you'll end up paying more in interest over the life of the loan. For example, a 6-year loan term may save you $85 per month, but you'll pay an additional $1,500 over the life of the loan.

Here's a comparison of two loan offers:

Don't focus on monthly payments alone; compare the total amount you'll pay over the life of the loan. Shop around and compare lenders to see what loan terms you can get from different banks.

Negotiate the APR, length of the loan, and dealer fees that may be rolled into the loan amount. You can also negotiate the purchase price of the car and the value of a trade-in vehicle.

Your credit score is a crucial factor in determining whether you'll be approved for a car loan and what interest rate you'll qualify for. A good credit score can save you thousands of dollars in interest over the life of the loan.

To check your credit score, you can visit annualcreditreport.com and request a free report from each of the three major credit bureaus. This will give you a good idea of your credit history and help you identify any errors or issues that may be affecting your score.

A credit score of 670 or higher is considered good and will make it easier to qualify for a car loan with a low interest rate. If your score is lower, you may still be approved for a loan, but you may face higher interest rates or stricter terms.

Your credit score is based on factors like your debt-to-income ratio, employment history, and payment history. Lenders will also consider your credit report, which lists all of your past and current debts.

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Here's a rough guide to the average APRs for new and used cars based on credit score:

Keep in mind that these are just general guidelines, and the interest rate you qualify for will depend on a variety of factors, including your credit score, income, and the lender you work with.

A down payment can help you get better loan terms, like a lower interest rate, since lenders typically favor borrowers who make a down payment on their vehicle.

It's a good idea to know the dealer invoice cost of the vehicle and what it typically sells for in your area, so you can negotiate the lowest price and save on the purchase.

Putting more money down on the car can also help you avoid paying a higher interest rate than you deserve, which can wipe out any savings you made on the purchase.

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A down payment is the amount of money you put toward the car, and lenders typically favor borrowers who make a down payment, as it shows they are committed to the loan.

Making a down payment can help you get better loan terms, like a lower interest rate, because it shows lenders you're serious about paying off the loan.

The more money you put down on the car, the better loan terms you're likely to get, which can lead to lower monthly payments.

You can't borrow a down payment, so you'll need to have the cash on hand to make a down payment, which can help you qualify for better loan terms.

Financing a car can be a costly affair, and one of the biggest downsides is the total cost of ownership.

You'll end up paying more than the car is worth over the loan term, no matter what APR you secure.

Paying for a car in cash is a great way to avoid interest rates and other fees altogether.

Regardless of whether you're buying a new or used car, paying cash can save you a significant amount of money in the long run.

If you have your heart set on a certain type of vehicle, financing might not be the right option. Some financial institutions only provide loans for specific types of purchases, like a bank that might not give you a loan to buy a car that's more than 10 years old.

Limited vehicle options can be a major drawback of financing. This is because some lenders have strict age limits for the vehicles they'll finance.

You might be surprised at how many lenders have these age limits in place. For instance, a bank might not give you a loan to buy a car that's more than 10 years old.

In some cases, the lender might also have specific requirements for the vehicle's make, model, or condition. This can make it difficult to find financing for a vehicle that meets your needs.

For another approach, see: How to Buy a Car with Your Own Financing

Dealerships often have captive lenders that offer subsidized car loans with good credit, but you can find better terms elsewhere.

You can shop around for a loan at your bank or credit union, especially if you have a good relationship with them. In fact, car loans from credit unions may offer lower rates and fees than banks.

Online lenders like Autopay can help you gather multiple loan quotes with a single application, but be prepared for a flurry of phone calls or emails.

Captive lenders are often the only way to get incentive financing, such as a 0% APR on auto loans, but you should also consider other lenders.

Online lenders like LightStream may have the lowest interest rates on the market due to lower overhead costs.

Banks and credit unions offer auto financing for new and used cars, and you can get prequalified on your own.

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