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Car Finance 101: Everything You Need to Know

Whether you financed a dozen cars or you 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, you can be proactive, do some homework, shop around, and get the best deal possible.

If you pick the second option, we’ve put together this guide as a road map of sorts to help you navigate the financing process.

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. To help you get into the proper frame of mind, here’s some simple math.

According to the consumer credit experts at Experian, the average amount borrowed to buy a new vehicle in 2021 is just over $35,000. Let’s say that’s what you’re financing. If you finance that amount for 60 months (5 years) at 4% interest, you will pay $645 per month. Your total interest paid over those 5 years will be $3,675.

Knocking just one point off that interest rate to 3% reduces the monthly payment to $629. Total interest paid over those 5 years drops to $2,734.

Yep, that’s a savings of $941. Hey, suddenly you have the cash to buy that new 60-inch flatscreen TV.

If that makes sense to you, please read on.

What Is Financing a Car?

Financing a car means borrowing the money and paying it back over time to buy that car today. This is how most of us buy a vehicle. Some lease cars and some finance, but nearly all of us use someone else’s money to purchase a new or used vehicle.

At the time of purchase, we sign an agreement to pay a set amount each month for an agreed-upon number of months at the end of which, the agreement is fulfilled.

Using that borrowed money, however, isn’t free. We must pay for the borrowed money. The amount we must pay is known as interest. It is part of those monthly payments, along with the sales tax and other fees.

Again, from Experian, the average number of months for a car loan in 2021 is 69 months. The average interest rate is 4.09%.

RELATED STORIES: Car Financing: Are Taxes and Fees Included?

What Determines the Interest Rate?

Much goes into determining a buyer’s interest rate. The person’s credit score, credit history, the amount of the loan, the length (term) of a loan, and so forth are weighed by the lender when assigning an interest rate.

Beyond that, different lenders may assign you different interest rates based on the same information. This is why shopping your loan around to several lenders makes good financial sense.

We discuss this in more detail below.

What Are the Two Ways to Finance a Car?

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

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 on time, whether with a credit card or money borrowed from a lender, has a certain comfort level 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 than new. The average new car interest rate in the first half of 2021 was 4.09%. It was 8.66% for used cars.

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

Car Financing With a Lease

We aren’t going to go too far down the rabbit hole here on leasing. However, it does represent about one-third of vehicle financing.

The main ingredients of a lease are really the same as a car loan. Although the key ingredients are similar, the two processes offer little in common and bring totally different outcomes.

Think of leasing as a long-term rental. You never own the car, share in its equity, or have anything 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, the term of a lease is 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 – which is called the “money factor” in leasing – is based on the purchase price.

On 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. At the end of the lease, the car still belongs to the lender.

Issues With Leasing

Leases are also 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 payments. At best, you will face huge penalties.

At the end of the lease, if the vehicle shows only signs of normal wear and tear, you can probably hand back 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 may have exceeded. You will pay a penalty for each mile you drive over the limit.

The good news, though: You usually have the option of buying the car at the end of the lease. If you do, you avoid those penalties.

How Financing a Car Works

When you drive off a dealer’s lot in a new car, the dealer has been paid for it in full. Either you paid for it or some lending institution did.

You may have had a trade-in covering some of the transaction cost of the new car and then you paid the rest in cash. Otherwise, you borrowed at least some of the cost of the new car from a lender.

Most of us wind up borrowing at least some of the cost from a lender.

Whatever that leftover balance is will be the loan amount. In other words, the amount financed.

If you don’t already have financing in place at the time of the purchase, you will need to apply for a loan and wait while it’s approved. When your credit is good, approval might take 15 minutes. If your credit is not so good, it could take a day or two as the dealer shops the loan around.

In any case, before driving off in your shiny new car, you will typically sign a binding agreement to pay back the lender. The final loan amount will include the purchase balance and any cost or fees related to borrowing the money. These costs and fees will include the cost of borrowing the money (interest) and any fees the lender requires to make the loan.

The agreement also sets the loan’s term, otherwise known as the loan’s length. It will be stated in months: 24, 36, 48, and so forth. Your monthly car payment will be the exact amount required to pay off the loan balance at the end of its term.

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.

Why Is a Short-Term Loan Better?

Whenever you make a monthly payment on a mortgage, a credit card, a car loan, or any formal loan, the payment gets split. Part of it goes toward paying down the purchase balance (principal) and part goes to paying the interest.

Car loans are installment loans. In other words, the lender calculated the interest over the term of the loan and baked the amount into the monthly payment for the vehicle. However, even though that monthly payment is fixed, part of it goes to the principal and part to the interest.

Early in the loan, most of each monthly payment goes toward the interest. That’s why you may need to be three years into a 5-year loan before you obtain any equity in the vehicle. In other words, you don’t accumulate any value for the first two or three years. The longer the term of the loan, the longer it takes to begin accumulating value.

Until you reach the point at which the car is actually worth something as a trade-in, you are upside down in the loan.

If you want to pay off the loan early, the lender will quote you a payoff amount that is lower than the sum of your remaining payments. That’s because when you reduce the loan term, you are reducing the cost of the borrowed money.

Car Financing Options

When financing a car purchase, you have the option of financing the deal on your own or through the dealership.

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 preapproved.

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 yourself around to a few lenders. You can get preapproved at banks, credit unions, and finance companies.

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

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

After speaking to a few lenders, you will have a good idea of 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 preapproval in your hand.

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

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 other carmakers created their own financing divisions. Ford Motor Credit and Toyota Financial Services, for example, are known as “captive lenders” because they are tied to a particular carmaker.

These captive lenders often run low-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.

If you find yourself at a franchised dealer shopping for a certified pre-owned (CPO) vehicle, 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 haven’t been able 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

However, if you seriously tried to secure your own financing and couldn’t, the dealer might offer some options to make something happen. The dealer is motivated to sell you a car. If financing exists 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 relatively high-interest rate. Just keep in mind, you can always get up, go home, and think about it. The deal will still be there tomorrow.

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

Determining Your Monthly Payment

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

Lowering the transaction price involves not only negotiating down the sale price of the vehicle, but maybe scaling back on the car you hope to buy. Do 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. The car you want will be there tomorrow.

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?

In securing financing, your credit score isn’t everything, but it’s a honking-big thing. Your credit score works as 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 goes up or down on a weekly basis. 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 a credit score for you.

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 credit reporting agency Experian breaks down the numbers:

    • Super Prime: 781-850
    • Prime: 661-780
    • Nonprime: 601-660
    • Subprime: 501-600
    • Deep subprime: 300-500

To help you understand where your credit score stands in the bigger picture of car financing, we’ve pulled these three statistics from a recent 2021 Experian report on the latest trends in car financing.

    1. The average credit score for a new car loan is 732.
    2. For a used car loan, it’s 665.
    3. Only 17% 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:

  • 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 all the balances combined are $9,800. It’s a problem.
  • 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 interest rates remained so low for so long that most people see no reason to refinance. It’s doubtful you can get a better interest rate today than you did two years ago.

However, maybe you didn’t do your homework when you bought that vehicle two years ago. Now, you realize you are stuck with an interest rate higher than you deserve. You can refinance. Or, if your credit had some serious dings, but your credit score is much higher today than when you got your car loan, you can refinance.

We’ll say it again, lenders want to lend. Your current lender will not be very motivated to refinance you at a lower rate, but another lender might.

Here’s the rub, you may still owe more on your car than it’s worth. It’s that “underwater” thing we talked about earlier. If your credit score is really high or you are willing to put down more cash, a lender might take the leap.

If you are considering refinancing, you need three numbers: your credit score, the payoff amount of your current loan, and the current book value of the vehicle.

Is Financing a Car the Best Choice for Me?

Unless you are a one-percenter, chances are you need to finance some part of your new car purchase. Cash is better. Maybe consider a used car you can pay for in cash.

Otherwise, you will need to finance or lease. Leasing isn’t a good idea unless you are doing it for business purposes. Yes, you do 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 yourself around to several lenders and find the best deal that way.

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.
  2. Calculate the costs of ownership: This only has to do with financing a car to the extent that you want to be able to afford the monthly payment. Research the cost of insurance, monthly maintenance, and fuel costs. Will the total cost of ownership fit within your budget?
  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, the national consumer-credit agencies must provide you with your credit report each year, but you have to request it.
  4. Save a down payment: If you don’t have a trade-in, you may need to put some money down. Lenders like to see a borrower have some financial skin in the game. They see you as less of a risk. Try to put together at least 10% 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.

See new cars for sale near you and See used cars for sale near you

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Russ Heaps
Russ Heaps is an author specializing in automotive, financial and travel news. For nearly 35 years he has covered the automotive industry for newspapers, magazines and internet websites. His resume includes The Palm Beach Post, Miami Herald, The Washington Times and numerous other daily newspapers through syndication. He edited Auto World magazine, and helped create and edit NOPI Street... Read More about Russ Heaps


What Is the Difference Between Leasing and Financing a Car?

With leasing, you are paying for the use of the car. The monthly payments cover the estimated lost value during the term of the lease and the interest rate on the cost of the vehicle. At the end of the lease, you give the car back. With financing, you are actually buying the car. At the end of the loan, the car is yours.

What Is a Finance Charge on a Car Loan?

Any time you borrow money from a lender for a purchase, there is a cost for that borrowed money. The finance charge or interest is how that cost is calculated. For an installment loan like a car loan, the finance charge is calculated and included in the monthly payment.

What Credit Score is Needed to Finance a Car?

Factors other than the credit score can come into play when a lender is considering making a car loan. Borrowers with a 300 credit score can find financing, but they will probably face double-digit interest rates. The average credit score is around 730 for a new-car loan and 650 for a used-car loan. About 80% of car loans go to borrowers with a credit score above 600.

Can You Trade In a Financed Car?

Yes, it’s up to the dealer to verify the payoff on your trade-in and then pay that amount to your lender. If you’re leasing, using the vehicle as a trade-in is not an option.

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