Car Finance 101: Everything You Need to Know

Quick Facts About Financing a Car

• Factors like credit history, credit score, loan amount, and loan duration determine the interest rate.
• Shop for the lowest interest rate before going to the dealership, then weigh the best option.
• If you need to repair your credit before buying, doing so can help raise your credit score.

Whether you financed a dozen cars or are new to the game, getting a loan for a car can be a daunting experience. Of course, you can sleepwalk your way through it, squeeze your eyes shut, and hope for the best. Or, be proactive, do some homework, shop around, and get the best deal possible.

The second option is better, and we’ve put together this guide as a road map to help you navigate the financing process.

• What Is Financing a Car?
• Understanding Interest Rates
• What Are the Ways to Finance a Car?
• Car Financing Options
• Determining Your Monthly Budget
• What Is Your Credit Score’s Role in Car Financing?
• Refinancing a Car
• Is Financing a Car the Best Choice for Me?
• What to Know Before Financing a Car
• Our Take

What Is Financing a Car?

Financing a car involves borrowing money, typically from a bank, credit union, or the financing arm of a car manufacturer, to purchase the car today and repay the loan over time. This is how most of us buy a new vehicle. According to Experian, 80.5% of new cars and 37.1% of used cars purchased in the first quarter of 2025 were financed. Some shoppers opt to lease, while others choose to buy. But nearly all of us use someone else’s money to purchase a new or used vehicle.

At the time of purchase, you sign an agreement to pay a set amount for a specified number of months, after which the contract will be fulfilled. Loan terms can vary, depending on the length of time you choose and what you can afford. However, most go between three and six years, or 36 to 72 months, although some can extend as long as seven years or 84 months. Experian’s 2025 Q1 report charts the average length of a new car loan at 68 months, a figure that has remained steady over the past few years.

Using that borrowed money, however, isn’t free. We must pay for it. The amount we must pay is known as interest. The interest plus any taxes and fees you roll into the loan are part of the monthly payment.

If you need help determining how much you can afford to pay for a car, use our guide to determine what fits your budget and what’s right for you.

Understanding Interest Rates

Spoiler alert: Your goal when financing is to land the lowest interest rate possible. Ensuring you get the lowest rate you deserve requires some effort on your part. Here’s some simple math to help you get into the proper frame of mind.

According to the consumer credit experts at Experian, the average amount borrowed to buy a new vehicle reached just over $41,700 in the first quarter of 2025. That average new loan amount is up about $1,000 since a year ago. According to Bankrate, the average annual percentage rate (APR) for a 60-month loan on a new vehicle as of August 2025 was 7.22%.

Using Autotrader’s car payment calculator, financing $41,700 over 60 months at 7.22% interest will result in a monthly payment of $830. The total interest paid over the 5-year period will be $8,103.

Knocking just one point off that interest rate to 6.22% reduces the monthly payment to $810. The total interest paid over those 60 months shrinks to $6,927.

Yep, that’s a savings of $1,176.

What Determines the Interest Rate?

To determine a buyer’s interest rate, a lender weighs the person’s credit score, credit history, loan amount, length (term) of a loan, and so forth when assigning an interest rate.

Furthermore, varied lenders may assign different interest rates based on the same information. Shopping around to several lenders for your loan makes good financial sense.

What Are the Ways to Finance a Car?

Basically, when you don’t pay cash for a car, you have two primary avenues for borrowing the money: leasing or financing with a loan.

Car Financing With a Lease

We aren’t going to head too far down the rabbit hole here on car leasing. However, consulting Experian’s 2025 Q1 report, leasing represents roughly 25% of all new vehicles purchased.

The main ingredients of a lease work similarly to a car loan. However, the two processes share little in common and yield entirely different outcomes.

Think of leasing as a long-term rental. You never own the car, share in its equity, or have anything tangible to show for those monthly payments at the end of the lease. The monthly payments are based on what the lender believes the car will be worth at the end of the lease.

Although they can be shorter or longer, lease terms are usually 24 to 36 months. Whatever the lender projects the vehicle will lose in value over the lease term is the basis for calculating the monthly payment. As with a loan, calculating the interest, also known as the “money factor” in leasing, is based on the purchase price.

On the one hand, the monthly payment for a lease is almost always less than the monthly payment for a traditional car loan. On the other hand, at the end of a car loan, the vehicle is yours, while at the end of the lease, the car still belongs to the lender.

Issues With Leasing

A big negative is that leases can be tough to break. If, for any reason, you need to get out of a lease early, you may not be able to without paying off the remaining balance. At best, you will face huge penalties.

When the lease concludes, if the vehicle shows only signs of normal wear and tear, you can likely return the keys and walk away. However, normal wear and tear is a subjective call that you don’t get to make. You may be penalized for some dings on the exterior and stains on the seats. Moreover, there is a mileage limit; You will pay a penalty for each mile you drive over the limit.

The good news is that lessees usually have the option to buy the car at the end of the lease. If you do, you avoid those penalties.

PRO TIP: In today’s tight used car market, a car at lease end may be worth more — sometimes a lot more — than the buyout price agreed to in the lease contract. In such cases, buying the vehicle, rather than turning it in, makes a lot of sense.

Car Financing With a Loan

This is how the majority of us buy a car. It’s usually fairly straightforward. Anyone who has purchased something, especially something pricey, using credit, should have a certain level of comfort with a car loan.

The main ingredients of a car loan:

• Down payment or trade-in
• Loan amount or balance, including taxes, title, and fees
• Term or length of the loan
• Interest rate or the cost of the money being borrowed

Most of what we discuss with loan financing applies to new and used vehicles. However, interest rates tend to be higher for used cars than for new ones. For example, the most recent Experian report shows that the average new-car interest rate (across all loan lengths) was 6.73% at the end of March 2025. The average length of used car financing was just over 67 months with an average interest rate of 11.9%.

With a car loan, if you make your payments on time, you own the vehicle at the end of the loan term.

Why Is a Short-Term Loan Better?

Auto loans are usually simple-interest, fixed-payment installment loans.

Similar to a mortgage, credit card, or formal loan, the monthly payment for your car loan is split. Part of it goes toward paying down the purchase balance (principal), while the other part pays the interest on the remaining balance.

Until you reach the point where the car is worth something (equity) as a trade-in beyond what you owe, you remain “upside-down” or “underwater” on the loan.

If you want to pay off the loan early, the lender will provide a payoff amount that is lower than the sum of your remaining payments. That’s because when you reduce the loan term by paying it off early, you are reducing the cost of the borrowed money. Paying off early generally reduces the total interest on simple-interest loans and may be subject to prepayment rules; so, check your contract.

Car Financing Options

When financing a car purchase, you have the option to either find a lender yourself or let the dealership secure one.

Direct Lending

Whether you decide to finance through the dealership or not, it’s a good idea to check out some alternatives. This is best done before ever heading to the dealership. It’s called getting prequalified.

In your quest to score the best financing deal, you need to know the best interest rate for which you could qualify. The easiest way to gain that knowledge is by shopping around to a few lenders. You can get prequalified at banks, credit unions, and finance companies.

The bank with which you regularly do business is an ideal place to start. However, keep in mind, lenders want to lend. You can visit any lending institution, sit down with a loan officer, and initiate the process.

Credit unions are well-known for offering low car loan interest rates. You might consider joining one.

After speaking to a few lenders, you will know how much money you can borrow and at what interest rate. If you like what you hear, you can walk into the dealership with a prequalification or a preapproval in your hand.

This allows you to negotiate your car deal with more confidence and gives you the freedom to shop multiple dealers.

Prequalification vs. Preapproval

Although they sound somewhat the same and both provide answers about how much you may be able to borrow, for how long, and at what interest rate, there are three significant differences between prequalification and preapproval by a lender.

1. Depth of verification: To prequalify you, a lender only performs a cursory, if any, investigation into the information you provide, which consists of the basics, such as where you are employed, for how long, and how much you make; whether you rent or own your home, and other general information. The lender often doesn’t verify the information; however, based on that information, the lender will provide an estimate of what it is willing to lend, the terms, and the interest rate if your information checks out. On the other hand, a preapproval involves supplying detailed information about your finances, employment, and home, including your Social Security number. All of which the lender verifies. If it all checks out to the lender’s satisfaction, the lender will preapprove a loan.
2. Credit score impact: Since the lender doesn’t conduct a full credit check with one of the national credit bureaus (Experian, Equifax, and TransUnion) when prequalifying a borrower, prequalification doesn’t affect the borrower’s credit score. You can collect as many prequalifications from as many lenders as you want without impacting your credit score. A preapproval, on the other hand, does involve verifying information with a national credit bureau. This alerts the credit bureau that you may add to your total debt with a new loan. This often triggers at least a small, temporary drop in your credit score, even if you don’t take out the loan.
3. Only one is binding: A prequalification is for you, more than the car dealer. Based on the information provided and its accuracy, it tells you what you qualify for from that specific lender. Not so with a preapproval. If a lender preapproves you, it will issue a document stating the terms of the loan for which you are preapproved. Typically, it is valid for a specified period, such as 14 days. As long as your credit situation doesn’t change in the meantime, the lender will preapprove the loan. In other words, it’s binding for the lender; however, you aren’t bound to make the loan. Whether you decide against buying a car or to find a different lender, you are not obligated to take the preapproved loan.

Dealership Financing

Financing through the dealer can go a couple of different ways.

The most obvious reason for financing a new car through the dealer is if the car manufacturer offers special financing. This happens regularly with most brands. You can only get the deal through the dealer.

Ford, General Motors, Toyota, and most other carmakers created financing divisions. For example, Ford Motor Credit and Toyota Financial Services are known as “captive lenders” because they are tied to those carmakers.

These captive lenders often run interest rate specials on certain models. Sometimes they don’t require any money down or offer interest rates as low as 0%. Such deals are reserved for buyers with excellent credit. These days, you will see fewer 0% deals due to supply shortages.

If you find yourself shopping for a certified pre-owned (CPO) vehicle at a franchised dealer, it can be very much like shopping for a new car. The brand’s captive lender may well be running financing and leasing deals on the vehicle you want to buy.

The other reason you might find yourself sitting in a dealer’s business office applying for credit is if you’ve been unable to secure your own financing. This isn’t a great position to be in.

It restricts your ability to shop around for a better interest rate and leaves you open to making a snap decision. That’s not the best strategy when borrowing thousands of dollars.

Bad Credit Car Loans

If you’ve tried to secure your own financing but were unable to do so due to poor credit history, the dealer may offer options. The dealer is motivated to sell you a car. If financing is out there, the dealer will find it.

If you are shopping for a used car, the dealer might even be willing to broker the financing or carry the loan.

In these instances, you are almost guaranteed to pay a high interest rate. Remember that you can always get up, go home, and think about it. The deal will still be there tomorrow.

If nothing else, you can work on your credit score while you wait.

Determining Your Monthly Payment

The monthly payment on the vehicle you are buying is a function of the transaction price, the down payment, the loan term, and the interest rate. That’s it.

Lowering the transaction price involves not only negotiating a lower sale price for the vehicle, but perhaps scaling back on the car you hope to buy. Do you really need a 12-speaker audio system or leather seats?

If you’ve done your homework, you should have a good idea of what the dealer invoice cost of the vehicle is and what that vehicle typically sells for in your area. If you don’t, excuse yourself, go home, and do the research.

Negotiating the lowest price on the vehicle you want, though, is only half the battle in scoring the best deal. You can wipe out what you managed to save on the purchase by paying a higher interest rate than you deserve.

This is why you need to know how lenders see you in terms of risk. You need to have at least a ballpark idea of the interest rate for which you qualify.

Even if a monthly payment seems affordable and within your budget, that doesn’t necessarily mean it’s the best interest rate you can get.

What Is Your Credit Score’s Role in Car Financing?

Your credit score isn’t everything in securing financing, but it’s big. Your credit score is a lender’s first impression of you as a borrower. Beyond your name and address, it’s the first thing a lender cares about.

Your credit score shows a snapshot of your credit health at any particular moment. It’s a number that can rise or drop every week. Moreover, you have more than one credit score at any given time. That’s right: Several agencies and financial institutions monitor your credit and maintain your credit score.

More than likely, all of these credit scores are similar, within 10 or 15 points, but they aren’t the same. Likewise, not every lender uses the same scale to rate credit scores.

Here’s how FICO, or Fair Isaac Corp., and VantageScore break down their scores. FICO is the more popular of the two scoring schemes. VantageScore is a joint venture of Experian, Equifax, and TransUnion, the three most prominent national credit reporting services.

FICO

Source: FICO

VantageScore

Source: VantageScore

FICO vs. VantageScore: How They Differ

Although many financial institutions own credit score systems, the two big dogs are FICO and VantageScore. As we see above, both score from 300 to 850; however, they slice up the pie a little differently. Where FICO has five categories, VantageScore has four. That’s not the only difference, either.

They also differ in the weight they assign to the categories. Here’s where they place their emphasis, measured in percentages, according to Bankrate.

 FICO

VantageScore

Where You Stand

To help you understand where your credit score stands in the bigger picture of car financing, we’ve pulled these three statistics from the 2025 Q1 Experian State of Auto Finance Market Report. It’s the latest glimpse into current auto financing trends.

1. 1. The average credit score for a new car loan is 756.
   2. For a used car loan, it’s 684.
   3. Only about 16% of loans and leases for new and used vehicles went to borrowers with a credit score below 601.

Tips for Repairing Your Credit Score

If your score is below 600, it’s not the end of the world, but you have some work to do. We offer these tips to help build a better credit score:

• Reduce balances on loans. Pay off whatever loan balances you have. One of the factors negatively impacting a credit score is a high ratio of loan balances to your overall credit limit. In other words, if all your accounts combined have a total credit limit of $10,000 and their combined balances are $9,800. It’s a problem.
• Keep accounts current. Do your best to settle delinquent balances. Besides bankruptcy and repossessions, late payments are historically the biggest drag on a credit score.
• Abstain from new credit. Likewise, avoid opening new accounts. Credit scores respond positively to older, established accounts and not so much to new ones.

Refinancing a Car

Car loan rates are still elevated but have eased a bit in 2025 as the Fed began cutting rates in September. Five-year APRs on new cars are hovering between 6.8% and 7.2% on average, while used car APRs are still near 11%, so refinancing can work out if you locked in at peak rate in 2023-2024 and your credit has improved.

That said, lenders are cautious, and many owners are underwater — more than 1-in-4 trade-ins carried negative equity in Q2 2025 — so approval and pricing often depend on your loan-to-value. If you owe more than the car is worth, you may need cash at signing or very strong credit to make a refinance work.

Refinance if:

1. Your new ARP meaningfully beats your current rate.
2. Fees are low.
3. You’re not stretching the term so far that the total interest rises.

To decide quickly, pull three numbers — your credit score, your current payoff, and your car’s current market value — and compare offers from multiple lenders (banks, credit unions, and captives).

Your current lender may not be very motivated to refinance you at a lower rate, but another lender might be.

Is Financing a Car the Best Choice for Me?

Unless you are a member of the 0.01%, you will likely need to finance some part of your new car purchase. Cash is better. Consider a used car that you can purchase with cash.

Otherwise, you will need to lease or finance the vehicle. Leasing isn’t a good idea unless you do it for business purposes. Yes, you have a newer car to drive for two or three years, but then what? You may find yourself paying hundreds of dollars in mileage overages and damage penalties.

If you can’t pay cash, a car loan is an answer. Look for those carmaker-sponsored financing specials and take advantage of one. If you can’t find one that works for you, shop around with several lenders and find the best deal.

What to Know Before Financing a Car

1. Research the car you want: In today’s connected world, there is no excuse for not being armed with all the pricing information on the car you are considering. This includes the dealer cost and average transaction price, which topped $49,077 in August 2025, according to Autotrader sister company Kelley Blue Book.
2. Calculate the costs of ownership: Besides knowing if you can afford the monthly payment, research the ownership costs of the car. Those include insurance, monthly maintenance, and fuel expenses. Will the total cost of ownership fit within your budget? Try our sister site’s ownership cost estimates tool to get a better idea.
3. Determine your credit score: Your bank or credit union may track your credit score. If not, reach out to Experian or one of the other national consumer credit agencies. While you’re at it, get a copy of your credit score. By law, national consumer credit agencies are required to provide you with your credit report free of charge each year, but you must request it.
4. Save a down payment: If you don’t have a trade-in, you may need to put some money down. Lenders prefer borrowers to have some financial skin in the game. They see them as less of a risk. Try to gather at least 10% to 20% of the vehicle price.
5. Secure a co-signer: If your chances of securing financing look really grim, a co-signer might be enough for a lender to take a chance.

Our Take

If you stuck with this from beginning to end, no doubt you are in the market for a car, with plans to finance at least a portion of the purchase. We hope that if we’ve driven one thing home, it’s that nothing surpasses preparation when financing a car, or any other major purchase, for that matter. Roll up your sleeves and get to work. You should know your credit score, the vehicle’s average purchase price in your area, the interest rate you qualify for, and the book value of your trade-in, as well as any outstanding loan balance on it. With all of this information in hand, you are poised to score the best financing deal possible.

Editor’s Note: This article has been updated since its initial publication.