How to Finance a Car: A Step-By-Step Guide

While shopping for a new car can be exciting, many car buyers often neglect to consider financing until the last minute. However, obtaining the right car loan should be one of the first steps in the car-buying process. Although it is crucial to find a vehicle that meets your needs and budget, figuring out how to pay for it is equally important.

Most car buyers cannot afford to pay for a new or used car outright and will need to secure an auto loan to cover some or all of the vehicle’s cost. With the help of hassle-free online auto loan tools, comparing lenders and applying for loans has become much more accessible during the COVID-19 pandemic.

Once you know how much you can borrow, the interest rate you qualify for, and how long the loan term will be, you’ll have a better understanding of the car you can afford. Selecting the right auto loan can save you money, while choosing the wrong one can be costly, potentially damaging your credit.

However, it’s essential to remember that auto loan payment is just one part of owning a car. You’ll also have to consider fuel, maintenance, insurance, and parking fees. Therefore, your monthly payment must fit your budget while also paying off the balance as soon as possible.

Before selecting a car, you must do your homework to ensure that it meets your specific needs, such as fuel economy, functionality, and insurance requirements. By getting the entire package and considering the total cost of ownership, you can make a well-informed decision rather than focusing solely on the monthly payment.

Our new and used car rankings can help you find the right vehicle, and the following steps can guide you through obtaining a great deal on your car loan. Instead of waiting until you’re in the dealership’s financing office, it’s smart to plan your financing before heading to the dealership. This way, you’ll know precisely how much car you can afford and avoid potentially overpaying for your loan. While the dealership may offer financing options, if you already have a plan in place, you’ll have the leverage to negotiate a better deal.

1. Learn the Language of Lending

Before embarking on your auto financing journey, it’s important to familiarize yourself with certain essential terms. Here are some of the most crucial:

Car Loan (also known as auto loan or car financing): This is a contractual agreement between you and a lender wherein the lender provides you with the cash to purchase a new or used vehicle, and you agree to pay it back over time. Unless you qualify for a 0% financing deal, you’ll be required to pay interest each month on the outstanding loan balance. Some lenders may also charge a loan fee.

Interest (also known as finance charge): Interest refers to the cost of borrowing money from the lender, expressed as an interest rate (usually the annual percentage rate or APR). The interest rate covers the lender’s expenses and risks, while allowing for a profit margin. The loan papers will specify the interest rate for the loan.

Interest rates can fluctuate over time, and your credit history, loan term, and type of vehicle can all impact the APR you’ll be offered. Different lenders may also offer varying interest rates for the same vehicle.

Car Loan Term: The loan term is the duration of the auto loan, usually stated in months. In the past, loan terms of 36 to 48 months were most common, but as cars have become more expensive, loan terms of 60 to 72 months or even longer have become increasingly common. To determine the number of years it will take to pay off the vehicle, you can divide the loan term by 12.

Longer loan terms typically involve higher interest rates, as they present more risk for lenders. Ideally, you should opt for the shortest loan term you can afford to avoid having to pay for costly car repairs while still making loan payments.

Principal: The loan principal is the balance of the loan, which initially equals the total loan amount. As you make monthly payments, the principal decreases. A portion of each payment goes towards interest, and the remainder goes towards paying down the principal.

Down Payment: A down payment is the amount of money you put towards purchasing the car at the time of sale, either in the form of cash, a trade-in, or both. The amount you need to finance is the difference between the car’s price and the down payment. For example, if you buy a $40,000 minivan and put down $10,000, you’ll need to finance $30,000.

Monthly Payment (or Car Payment): Every month, you’re required to make a payment towards the loan’s principal and interest, with a specific due date. Calculating monthly payments can be complex, but you can use a car payment calculator to find out the amount.

When comparing auto loans, it’s essential to look at the total cost of the car, including interest, rather than just the monthly payment or loan term.

Credit Score: A credit score is a three-digit number that reflects a credit reporting agency’s evaluation of your credit history. A higher score is better, and it’s based on factors such as payment history, credit usage, and credit types.

Vehicle Title: This is a state-issued document that proves ownership of a car. The lender holds the title until you pay off the loan.

Loan-to-Value Ratio: This is the ratio of the loan balance to the car’s cash value. Ideally, you want this number to be less than 100%; if it’s 100% or higher, you’re considered “underwater” on your car loan.

2. Know Your Credit Score and Understand Why It Matters

Your creditworthiness and ability to repay a loan, including an auto loan, are captured by your credit score, which condenses the information from your credit report into a three-digit number. Higher scores indicate a higher likelihood of loan repayment, while lower scores indicate a greater chance of default.

Different credit reporting companies use different methods to determine scores, resulting in multiple credit scores. The main credit bureaus are Experian, TransUnion, and Equifax, and your credit score may be referred to as your credit rating or FICO score. Most credit-scoring models range from 300 to 850 points, although some use alternative scales, and scores are not directly comparable across models.

A high credit score increases the likelihood of obtaining a car loan with a low interest rate, while lower scores may result in a more challenging loan application process and higher interest rates. Generally, a score of 720 or above on most scales and a stable employment history should make financing easy to obtain.

What Goes Into a Credit Report?

Your credit score is affected by several factors, with the most crucial being your history of making on-time payments and whether you’ve defaulted or been delinquent on any financial obligations. A higher frequency of late payments will result in more points being deducted from your score. Additionally, if a lender had to write off an unpaid balance, you’ll have a derogatory mark on your credit for several years.

The amount you owe compared to the amount of credit you have available is also significant. Using a high percentage of available credit, such as 90%, will hurt your score more than using only 30%. If you’re thinking about closing credit cards, wait until after your auto loan has been approved. Closing cards reduces your available credit and raises the percentage of credit you’re utilizing, which will negatively impact your score.

The age of your accounts and their recent activity are also factors that lenders take into account when determining your credit score. They prefer to see stability, and recent account openings can result in a significant decrease in your score. Furthermore, the type of credit accounts you have, such as revolving accounts (credit cards) or installment accounts (car payments), are also taken into consideration.

Lastly, your score reflects your recent attempts to obtain credit. Every time you request your score from a potential lender, your score drops a bit. However, if you request multiple inquiries within a short period for the same type of activity, such as a new auto loan, they’re treated as one request and won’t have a significant impact on your score.

In most cases, your credit score won’t include your payment history with utility or cell phone companies. Recently, Experian began offering a service that adds your payment history on those types of bills to your credit score. Opting into the program raises participants’ credit scores by an average of more than 10 points, according to the company.

How to Find and Fix Dings in Your Credit Report

Discovering credit issues at the dealership when trying to buy a car is a bad time to learn about your credit situation. To avoid being caught off guard, you can obtain a free copy of your credit report from the three main credit bureaus each year. Although the score itself is not required by law, it is often provided by lenders and credit card issuers.

Before beginning your car buying journey, it is advisable to scrutinize your credit reports for errors and negative information. Checking your own credit report does not harm your credit score like an inquiry from a lender. Correcting errors may take time and it can take several months of making timely payments to significantly improve your score.

If you need to make multiple significant purchases that require good credit, stagger them to prevent a significant impact on your credit score. Closing credit cards may not be the best strategy for improving your score, as it may increase your credit utilization and decrease your score.

If you end up having to accept unfavorable terms on an auto loan, keep in mind that you can typically refinance your car loan later. Be mindful of prepayment penalties, but refinancing may save you a significant amount of money if your credit score improves before you refinance.

3. Find a Good Financing Deal

Auto loan interest rates are determined by various factors, including the lender’s risk appetite, the loan-to-value ratio, your creditworthiness, and market demand. Different lenders can offer significantly different rates and terms, so it’s important to shop around and compare offers to find the best deal. With some research, you can easily find lenders offering competitive rates and promotional offers with favorable terms.

4. Apply for a Car Loan the Right Way

To secure the best possible deal on your car loan, it’s advisable to apply to several lenders and select the offer that works best for you. This process may take some time and require you to share your personal information with different financial institutions.

Submitting multiple loan applications in a short time frame is acceptable and won’t harm your credit score. However, spreading them out over several months can negatively impact your credit rating since each application will be treated as a separate inquiry.

It’s crucial to have a pre-approved loan offer before you visit the dealership, even if you ultimately decide not to use it. Ideally, you should obtain preapproval at least a week before you start actively looking for a car. This timing will give you the freedom to shop around without the pressure of time constraints or the fear of hurting your credit score with multiple inquiries.

When you fill out loan applications, expect to provide detailed information about your employment history, financial status, and social security number to authorize a credit report. Make sure all the information you provide is accurate and complete to avoid potential problems in the future. Providing incomplete or false information can result in your loan application being rejected, and the lender may immediately place your loan in default status and demand full payment.

5. Carefully Look at Dealership Financing Offers

Once you have secured a preapproved financing plan and researched your options for a used or new car, it’s time to move on to the exciting part: car shopping. Having a financing plan in hand that you can afford can help alleviate much of the stress of the process, allowing you to focus on negotiating a favorable price for your new car and a reasonable deal for your trade-in.

Car salespeople usually try to package the three elements of auto buying – the car price, trade-in value, and financing – into one monthly payment, while you prefer to treat each element as a separate transaction. You can do this in a few ways.

While honesty is always the best policy, you don’t have to provide every piece of information that the car dealer asks for. You can simply say that you haven’t decided on how you will pay for the car or whether you will trade in your old one. The longer you can keep the focus on the price you are willing to pay for the car, the better. It’s essential to remain courteous – salespeople are less likely to go to bat for someone who is unpleasant.

Ultimately, buying a car is a business transaction. You want the best price, while they want the most profit. A fair deal can be found somewhere in the middle.

6. Finalize the Deal

After reaching a mutually acceptable agreement with the seller, it is time to proceed with the paperwork. It is crucial that you carefully read all documents to ensure that they align with the agreed-upon terms and do not include any costly additions or blank spaces. In case there are any mistakes or empty fields, insist on correcting or filling them in before signing the papers. If the finance officer suggests that you sign the papers and they will address any issues later, you should politely decline and state that you will only sign the documents once they are accurate.

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