Financing is a popular option for car ownership: Over 80% of new vehicles purchased in the United States are financed.
The concept of financing is straightforward: You take out a loan for your new vehicle either via the dealership or another lending institution, negotiate the interest rate, down payment, and term of your loan and sign the deal. When the term is up and all payments have been made, the loan is discharged and the vehicle becomes yours.
In practice, however, car financing can be more complicated. The length of your term, along with your interest rate, your down payment, and any other extras on the loan, can change how much you pay both upfront and over time.
What Goes Into Financing Your Car?
Several factors come into play when banks or dealerships determine if you are eligible for a loan and the amount of money you’re eligible to borrow, including:
Credit scores are used to assess how likely you are to pay back loans on time and without defaulting. Common components of a credit score include your bill-paying history, any unpaid debts, the type and number of your current loan accounts, how much of your available credit you’re using, and any new applications you have for credit, including your application for vehicle financing.
Credit scores typically range from 300 to 850 but vary based on the credit model used to calculate your score, which may differ slightly between dealerships, banks, and other financial institutions. Your credit score affects the financing terms and offers you get from dealerships or banks — the higher your score, the more favorable your terms. For example, you may be offered a lower interest rate if you have a high credit score.
Prequalification is an estimation of the loan terms you may receive based on the limited financial and personal information that you provide to lenders. You may see a wide range of potential interest rates after a prequalification check, and your eventual rate may change based on your full credit history. The benefit of prequalification is that it’s considered a soft credit check, which means it won’t impact your credit score.
For example, you might contact your bank and ask about prequalifying for a loan based on the financial products you currently have with the institution, like credit cards or a checking account. Using a soft credit check means you can prequalify multiple times with multiple lenders with no damage to your credit score, but it also means the eventual rate may be higher (or lower) than initial estimates because it is based on limited data.
Preapproval happens after a lender has reviewed your entire credit report and conducted a hard credit check, which can negatively impact your score if too many hard checks are performed in quick succession. Preapproval provides a more accurate range of term options and interest rates and typically occurs before the purchase of a new car.
In practice, you might ask for a preapproval from a dealership based on your credit report. The benefit here is that you may get close to the rate and term offered, but the potential drawback is that if you don’t get the offer you’re looking for, the hard check on your credit could negatively impact your score, especially if you go to another dealership and seek preapproval again.
Interest, or Finance Charge
Finance charges include the fees charged by lenders for a loan. These charges include interest rates but may also include specific lending fees, penalty fees, and other fees which the lender must disclose prior to completing the loan.
Lending fees may take the form of a flat fee for the service of lending money, while penalty fees may only apply if you miss payments on your vehicle.
Your interest rate is the amount you pay to borrow the money from your lender and may be calculated as simple or precomputed interest. In a precomputed interest loan, the amount of interest you pay over the life of the loan is calculated and set at the beginning of the term. Even if you choose to pay off the loan faster, you still owe this amount of interest.
Meanwhile, in a simple interest model, interest is calculated each time your payment is due: monthly, weekly, or every other week. Simple interest loans are also amortized, which means you pay more toward interest at the beginning of your term and more toward the principal near the end. For example, you could finance a $40,000 vehicle with no down payment at 5% interest for 60 months using a simple interest loan. Using an online loan calculator, you’ll find that you pay $45,290.96 over the term of your loan, or $5,290.06 worth of interest.
The lower your interest rate, the lower the total amount of interest paid, so long as the term stays the same. For example, if you pay 4% interest over 60 months on $40,000, your total interest paid is $4,199.65. However, if you extend that term to 84 months at 4% on $40,000, your total interest increases to $5,927.19.
Your down payment is the amount you pay upfront for your car before taking out your loan. This amount is subtracted from the total purchase price of your vehicle, in turn making your total loan amount smaller. Put simply, the more you can put down, the less you may pay over time.
Depending on your credit history and any conditions from the lender, you may need to put down 5%, 10%, or 20% of the purchase price before your loan is approved. Some dealers may offer 0% down financing, which means you don’t need any down payment to obtain financing so long as your application is approved.
As an example, 0% down on a $40,000 car at 5% interest over 60 months comes out to $5,290.06 worth of interest. However, if you choose to put $5,000 down, your total loan amount drops to $35,000 at 5% over 60 months, which comes out to $4,629.59 worth of interest over the same period.
The loan term is the length of your loan agreement. Common terms include 60 months (5 years), 72 months (6 years), and 84 months (7 years). The longer your term, the lower your monthly payments, but the higher your total interest paid over time.
For example, you may buy a $40,000 vehicle with a $10,000 down payment at 5% interest over 60 months. In this case, you would pay $566.14 each month and pay $3,969.22 in interest over the life of the loan. If you extend your term to 72 months, you would pay $483.15 each month and $4,786.65 worth of interest over the life of the loan. If the loan term is extended further to 84 months, you would pay $424.02 per month, but increase interest paid to $5,617.45 over the entire term.
Extras may include things such as dealership fees, gap insurance, and protection plans for your vehicle. Dealerships fees may include title and registration fees if the dealership handles this process, along with any applicable sales tax on vehicles. If your vehicle is delivered from the factory, you may be charged a destination fee. Also, documentation fees are common to account for the paperwork that goes into processing a financing application.
Guaranteed asset protection (GAP) insurance is designed to cover the difference in your loan amount and the amount your car is worth when you drive it off the lot — which is less than your total loan amount due to depreciation. If a car is totaled right after purchase, insurers often pay for the current value, not the loan amount. This would leave you with additional costs. GAP insurance makes up the difference and may be available from either the dealership or your current insurer.
Car dealerships often offer protection plans to help mitigate the costs of damage or wear and tear on cars. Common plans include windshield and tire protection, credit insurance, and extended warranties. It’s worth carefully reviewing these plans before agreeing to anything. Some, such as extended warranties that cover the entire vehicle for the term of your loan, may be worth the price, while others, such as dent or windshield protection, may be difficult to claim.
Any extras you don’t pay for in cash are added to the total value of your loan.
Finally, consider your budget. Determine what you want to spend, what you’re willing to spend, and how much you can potentially afford by getting preapproved or prequalified. It’s also worth watching out for any offers of lower payments with longer terms, especially if used to convince buyers that they can afford more expensive vehicles. By increasing the term, dealerships can create loans with lower monthly payments, but the interest over time may put you well over your preferred budget.
Leasing vs. Financing Your Car
Instead of financing your car, you could choose to lease your new vehicle. If you lease a vehicle, you don’t pay to own it. Instead, you pay to use it for the term of the lease. As a result, lease payments are lower than financing payments since you’re paying for the car’s depreciation over the term of the lease, not its total value.
Meanwhile, if you finance a vehicle, you’re paying to own it. You take out a loan for the car’s current value and pay it back over a fixed term. When the term is over, the car is yours.
Depending on your needs, either leasing or financing may be the right choice. For example, if you need a car occasionally but not often, you may benefit from a lease with lower payments because when the term is up, you can lease a new vehicle. However, a downside is that leases may have restrictions on how many miles you can put on the vehicle and may also mandate regular oil changes, inspections, and more.
Financing may be a good choice if you plan to keep using the vehicle after the loan term is over and if you have a down payment to help offset the total cost. However, if your car is seriously damaged or written off in the first few years of your loan, you may find yourself owing more on the loan than an insurance claim would pay out.
What is the Process for Financing a Car?
Financing a car usually starts at the dealership: You find a car you like, talk to a salesperson, and they begin the financing process. Documents you need include your driver license, credit history, proof of income, proof of residence, proof of insurance, and your current vehicle registration if you’re trading in your current car as a down payment on your new vehicle.
Once you have an offer from the dealership, it’s worth shopping around for other offers from other dealerships in your area. While you may have been given a great offer, it’s also possible you can find a better deal. Make sure to get any offers in writing to have a strong negotiating position.
You may also experience pressure to commit to a financing offer once your application has been approved. Some salespeople may say that the deal expires at a certain time or that interest rates will increase if you don’t immediately decide. This isn’t the case. Take the time to fully consider the offer before signing anything. If the dealership refuses to honor the original terms, it is advisable to take your business elsewhere.
How to Get the Best Financing Plan for Your Car
The more you know about how cars are financed and how car loans work, the better your chances of getting the right plan for your car.
Good practices for financing include:
- Be wary of extra costs: Costs outside the car itself, such as protection plans and gap insurance, can drive up the total amount of your loan. Wherever possible, avoid these costs or pay them in cash.
- Pay down as much as possible upfront: The more you put down on your car, the lower your monthly payments and the lower your total interest paid over time.
- Keep your loan term short: Shorter loan terms mean higher monthly payments but less interest paid over the life of your loan.
- Take your time: Don’t get pressured into a deal. Take your time and make sure the terms, conditions, and interest rate fit your needs.