Financing A Car: A Complete Guide To Getting An Auto Loan
Amid the bustling showroom of a car dealership, the scent of new leather mingles with the hum of excited conversations as potential buyers explore the sleek, polished exteriors of cars for sale. You can probably picture yourself behind the wheel of your dream car more easily than create a realistic budget for a car purchase. Fortunately, financing a car empowers you to own a vehicle that reflects your style and aspirations.
What Does Financing A Car Mean?
Financing a new or used car involves taking out a loan to cover the cost of the vehicle. Doing so allows borrowers to pay the loan via monthly installments over a specified period rather than paying the full amount upfront. Borrowers can take out car loans from banks, credit unions, online lenders and the auto manufacturer's financing department (also known as the OEM – original equipment manufacturer). All OEMs have separate financial institutions that provide financing for borrowers who purchase a car at the dealership.
You can finance a new or used car. Remember, dealerships only provide financing for borrowers who purchase from them. Fortunately, you can finance a car purchase from a private owner by applying at a bank, credit union or online lending platform.
Additionally, loans can be secured or unsecured. Typically, auto loans are often secured by the vehicle itself. If the borrower fails to repay, the lender can repossess the car. Unsecured loans, where the car doesn't serve as collateral, are less common and typically come with higher interest rates. As a result, most borrowers take out secured loans to reduce interest rates.
Financing Vs. Leasing A Car
Leasing a car means paying monthly to use a vehicle for a specific period, usually 2 – 4 years. The lessee (the person leasing the car) doesn't own the car; instead, they're essentially renting the car from the dealership. However, at the end of the lease term, the lessee can either purchase the vehicle or return it and potentially lease a new one. The leasing process differs from buying a car with a loan in several ways:
- Ownership: When you lease a car, you don't own the vehicle. Instead, you pay to drive it for a predetermined period, and at the end of the lease, you can return the car, purchase it or lease a new one. Remember, your lease payments don't go toward the purchase price.
- Monthly payments: Lease payments are typically lower than loan payments because you're only paying for the vehicle's depreciation over the lease term, not the entire cost of the car. However, the payments don't go toward purchasing the vehicle, meaning you'll always owe a monthly car payment when leasing.
- Mileage limits: Lease agreements often come with mileage restrictions (usually 10,000 or 12,000 miles per year). Exceeding these limits may result in additional charges.
- Wear and tear: Lessees are responsible for maintaining the car in good condition, and they may incur extra charges for excessive wear and tear at the end of the lease term. However, dealerships often pay for routine maintenance, such as oil changes.
- Customization: Dealerships usually forbid significant modifications to a leased car because the lessee must return the vehicle in its original condition.
Buying with a loan:
- Ownership: When you buy a car with a loan, you own the vehicle outright upon paying off the loan. You can keep the car for as long as you want and modify it as desired.
- Monthly payments: Loan payments are typically higher than lease payments because you're financing the entire cost of the car, not just its depreciation. However, once you pay the loan off, your monthly payments cease.
- Mileage: There are no mileage restrictions for owned vehicles, so you can drive as much as you want without facing extra charges.
- Wear and tear: You're responsible for maintaining the car, so there are no strict guidelines regarding wear and tear as long as you plan to keep the vehicle.
- Customization: Owners can customize their vehicles as they see fit.
How Does Financing A Car Work?
Financing a car means applying for and receiving a loan to fund your car purchase. Qualifying for a loan requires borrowers to have good credit and the income to afford monthly car payments. The following factors influence how much you’ll pay per month:
- Down payment: A down payment is an upfront payment the borrower makes to reduce the loan amount. The average down payment for a car is 20%. For instance, you would put $2,000 down for a $10,000 vehicle and take out a loan for $8,000 to cover the rest. While you can negotiate this number to make it more affordable, the lender may raise your interest rate to compensate. Remember, the more you put down, the lower your loan amount and the less risk you have of defaulting on the loan.
- Loan term: The loan term is how long the borrower has to repay the loan. Car loans usually range from 24 to 84 months. Remember, longer terms give you more months to pay, resulting in lower monthly payments but potentially higher overall interest costs.
- Interest rate: The interest rate, expressed as an annual percentage rate (APR), is the cost of borrowing money. A lower interest rate means lower overall costs for the borrower. The rate is influenced by factors like the borrower's credit score, the loan term and the economic environment.
- Title and registration fees: Buying a car requires you to record the title and register your ownership with your state government. The fees for doing so vary by state and can amount to several hundred dollars.
- Sales tax: This tiny percentage can significantly affect the final price of the vehicle. For instance, a $10,000 car with a 6% sales tax will cost $10,600. This amount eats into your down payment, so if you wanted an $8,000 loan in this situation, you would need to pay $2,600 upfront.
- Credit Score: Lenders assess the borrower's creditworthiness using their credit score. Borrowers with higher scores demonstrate more reliability, leading to lower interest rates and better loan terms. Borrowers with lower credit scores might pay higher interest rates or make a larger down payment to qualify for a loan.
- Loan amount: The loan amount covers the vehicle's purchase price minus the borrower's down payment. Some lenders may roll in additional costs to the loan, including taxes, registration and fees.
Pros And Cons Of Financing A Car
Like buying a house with a mortgage, buying a car with financing has benefits and drawbacks. Additionally, doing so is often necessary because most buyers don't have the cash to afford the car at the time of purchase. Here's what to consider:
Pros Of Auto Loan Financing
- You repay the loan in affordable monthly installments.
- Each payment addresses interest charges and the principal, building your equity ownership in the car.
- The interest rate is usually fixed, meaning your payment never changes.
- After the final payment, you own the vehicle outright, and the vehicle's fair market value becomes an asset.
Cons Of Auto Loan Financing
- According to Carfax, your car’s value drops by about 20% within the first year of owning it. Then, your car loses an additional 15% per year for 4 years. As a result, the average car is worth 40% of the sticker price after 5 years. So, your loan payments go toward a rapidly depreciating asset.
- Car loan payments are usually more expensive than lease payments.
- Down payments for car financing are usually higher than a security deposit for a lease.
- Interest increases your overall loan cost by hundreds or thousands of dollars over time.
How To Get An Auto Loan: Step By Step
Here's a breakdown of the steps involved in getting an auto loan:
1. Determine What You Can Afford
Evaluate your monthly budget to determine how much you can comfortably allocate to a car payment. You can do so by comparing your monthly income to your monthly debt obligations.
For instance, say you make $3,500 monthly and have $1,500 of debt obligations. So, you have $2,000 of income to put toward other debt payments, and your debt-to-income ratio is 43%. Lenders prefer DTIs of 50% or less, so your monthly income is in good shape for a car loan.
Remember, the average car payment ranges from about $530 to $730, depending on of it’s a new or used car. So, you will likely need several hundred dollars in your budget to put toward the car every month. Additionally, it's vital to include the costs of insurance, maintenance and fuel.
2. Review Your Credit Score
Obtain a copy of your credit report and check your credit score. Your credit score is the product of your borrowing history, demonstrating how consistently you've handled your debts in the past. A higher credit score generally results in better interest rates. You can get a free credit report annually from each of the major credit bureaus (Equifax®, Experian™ and TransUnion®).
3. Compare Lenders And Interest Rates
Research and compare auto loan offerings from various lenders, including banks, credit unions, car dealerships and online lenders. You can gather offers from lenders by submitting basic information on their websites. Then, you'll receive a prequalification verdict of whether each lender will give you a loan. Pay attention to interest rates, loan terms, fees, prepayment penalties and any special features.
4. Get Preapproved For A Car Loan
Once you narrow down your choices to one or two lenders, you can get preapproved for a loan. You'll submit more information for preapproval, including your full name, Social Security Number, contact information, and the car you'd like to purchase.
The preapproval includes the loan amount and the approximate interest rate the lender will provide. Remember, while it doesn't guarantee you'll receive the loan, it shows what the lender will likely offer you if you take the next step.
A word of caution: preapproval involves the lender performing a hard credit pull. Because hard credit pulls knock your credit score down a few points, it's risky to apply for preapproval with several lenders. Applying with a maximum of two is advisable to maintain your credit score.
5. Find The Right Car
Once preapproved, you can confidently shop for a car within your preapproved loan range. Visit dealerships or look for private listings for a car, considering the car's make and model, mileage, and condition. Then, negotiate with the dealer or seller on a final price.
6. Finalize Your Loan Terms And Buy The Car
Once you and the dealer agree on the price, notify your lender with the details from the purchase agreement. You'll also submit proof of income, residence and insurance to show your lender you're ready to purchase the car. Your lender will finalize the loan terms, including the interest rate, loan amount and repayment schedule. Then, they'll send you the paperwork to sign to receive the loan.
7. Start Making Your Monthly Payments
After finalizing the loan and buying the car, you'll start making monthly payments according to the agreed-upon schedule. To ensure you don't fall behind on payments, set up a system to ensure you pay for your car on time, such as automatic withdrawals or reminders. Remember, paying on time is crucial for maintaining good credit.
Auto Loan Financing FAQs
The answers to these frequently asked questions help sum up what it means to finance a car.
Is it better to lease or finance a car?
Leasing means paying monthly to drive a car you’ll never own with a mileage plan that limits how much you can drive. The payments are lower than financing a car, but the upside of financing is the payments end after 2 – 7 years. Additionally, financing means you’ll eventually own the car and can drive and modify it as much as you like.
What credit score do I need to finance a car?
While there’s no set minimum credit score lenders require for car loans, higher scores can help you get affordable interest rates and qualify with more lenders. For instance, a borrower with a credit score of 690 or higher can receive an interest rate of around 8%, while borrowers with scores of 619 or lower often receive rates of 16% or higher.
Can I use a personal loan to buy a car?
You can use a personal loan for any purpose, including buying a car. However, personal loans don’t use your car as collateral and are typically unsecured. As a result, they usually have higher interest rates than auto loans, increasing the cost of borrowing. That being said, if you don’t qualify for car financing or find a personal loan with a better interest rate than other offers, a personal loan is a viable way to buy a car.
Can I trade in a financed car?
You can trade in a financed car but will still have to take care of the loan. For example, the dealer may offer to pay off the rest of your loan. You could also trade for a cheaper car and use the remaining funds to pay off the loan.
Is it a good idea to finance a car?
Financing a car is advantageous because it enables you to acquire a vehicle without paying the full upfront cost, increasing accessibility for many buyers. Monthly payments can be manageable, allowing you to stick to a budget while building equity in a vehicle you'll eventually own. On the downside, the interest rates, potential depreciation and the total cost of financing over time are expensive. These factors may lead to higher overall expenses than buying a car outright or leasing.
The Bottom Line: Understand The Process Before Borrowing An Auto Loan
Financing a car offers a practical solution for buying a vehicle, particularly for those who prefer spreading the cost over monthly payments. It's crucial for borrowers to engage in thorough research, comparing lenders and interest rates to secure the most favorable terms and rates. Shopping around ensures that individuals obtain a loan tailored to their financial situation, potentially leading to lower overall costs.
Likewise, prospective car buyers should be aware that personal loans can also be utilized for financing, offering flexibility in choice. As interest rates, loan terms, and additional fees vary among lenders, taking the time to explore options becomes instrumental in making an informed decision. By understanding the intricacies of the financing process and considering individual preferences, borrowers can navigate the auto loan landscape and align their choices with long-term financial goals. You can also apply for a personal loan with Rocket Loans℠ to pay for a car or other expenses.