How Does Financing a Car Work?
Buying a car is a major financial investment, even if you buy a used model. To make the cost more manageable, many drivers choose to finance their car with an auto loan. When you finance a vehicle, you pay for the car in monthly installments, rather than one lump sum.
While an auto loan can help you afford a car more easily, there are also some downsides to consider. In this article, we'll explain everything you need to know about financing a car, including where to get financing and how to get the best loan terms for your situation.
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What Does It Mean to Finance a Car?
Financing a car means that you are buying the vehicle with money that was loaned to you by a financial institution, like a bank. You can either finance the full cost of a vehicle, or make a down payment using cash, and finance the rest of the purchase. You pay the loan off in monthly installments, plus interest, over a predetermined period of time.
Most auto loans are secured, meaning your car is used as collateral. If you stop making your loan payments, the lender has the right to repossess the car and sell it to get their money back. While you technically own a financed car (unlike a lease), the lender can still take the car back if you default on the loan or violate the loan agreement in any other way.
Factors That Make Up a Car Loan
Car loans can seem complicated, but they're actually fairly straightforward. Here are some car loan terms you should know before you apply for a loan.
A down payment is the amount of money you put toward the car. Lenders typically favor borrowers who make a down payment on their vehicle, because it shows they are committed to the loan.
Since you can't borrow a down payment (it must be made in cash you already have), putting more money down on the car can help you get better loan terms, like a lower interest rate.
Annual Percentage Rate (APR)
The annual percentage rate (APR) is essentially the cost of borrowing money. When you apply for a loan, the lender assigns you an APR based on your credit score, which determines your creditworthiness. For instance, if you have poor credit, the lender might consider you more likely to default on your loan and set a higher APR to mitigate the risk. Lenders tend to prefer drivers with good credit scores, which helps you qualify for a lower APR.
The loan term is the period of time you have to pay back the money you borrowed. Typical loan terms range from 36 to 72 months, but some lenders allow you to borrow money for shorter and longer periods.
Choosing a longer loan term allows you to pay off the car slowly, but it also means you'll pay more interest. If you can afford to spend more on your monthly car payment, consider opting for a shorter loan term. You'll pay less interest and you'll build equity in the car more quickly.
Advantages of Financing a Car
Financing a car can be a smart financial move for many people. Here are some of the benefits of getting a car loan.
Saving up enough money to pay cash for a vehicle can take years. With financing, you can get the money quickly. Even if you go to a local dealership without securing a loan beforehand, it's possible to apply for a loan, get the funds, and drive off in a new car on the same day.
If you're shopping for a car on a budget, you might also be considering a lease. But with a financed car, you will eventually own the car outright. You can choose to keep the car for years or sell it and use the money to buy your next vehicle.
Build Equity in the Car
When you finance a car, you still build equity in your car over time. At a certain point during the loan term, you will eventually own a bigger percentage of the car's value than what you still owe. For comparison, when you lease a car, you never build equity in the vehicle.
Another benefit of financing a car is that it can improve your credit score. Making your monthly payments on time shows credit reporting agencies that you're a reliable borrower. By building up your credit score now, you can potentially get more favorable loan terms in the future.
Downsides of Financing a Car
While financing a car is a popular option, there are some downsides to consider. Here are some things to know before you choose to get an auto loan.
One of the biggest downsides to financing a car is the cost. Regardless of what APR you secure, you'll end up paying more than the car is worth over the loan term. You can avoid interest rates and other fees by paying for a new or used car in cash.
Limited Vehicle Options
If you have your heart set on a certain type of vehicle, financing might not be the right option. Some financial institutions only provide loans for specific types of purchases. For instance, a bank might not give you a loan to buy a car that's more than 10 years old.
To mitigate risk, lenders often require borrowers to have a full coverage car insurance policy throughout the loan term. Full coverage policies include collision and comprehensive coverage that pay for your vehicle's repairs if you cause an accident. These policies are more expensive than minimum coverage policies, which only provide the minimum amount of required coverage in your state.
Where Can You Obtain Car Financing?
Many financial institutions provide auto loans. Here are a few places to look if you're thinking about applying for a loan.
Credit unions are nonprofit organizations that offer banking services and loans. If you have excellent credit, getting a loan from a credit union could help you get a lower APR. In general, a credit union's main objective is to serve its members rather than make the most profit, so it's worth researching local credit unions to see what your options are.
If you have an existing relationship with a bank, see if they offer car loans. While auto loans from banks sometimes have stricter requirements and higher interest rates, you might get a better deal if you're an existing customer and have adequate funds in your bank accounts.
Car dealerships work with a network of lenders to offer auto loans to car buyers on the spot. These lenders tend to charge the highest interest rates, but it's a convenient option if you don't have time to get a loan before you start car shopping. If you have poor credit, a dealership's lender might be willing to work with you in order to close the sale.
Online vs. In-person Auto Financing
There are a few ways to get an auto loan. You can visit a bank or credit union in person, which could give you the most leverage to secure a favorable APR. You can also apply for a loan at the dealership through one of their lenders. Applying for auto financing online is probably the easiest option. You can apply from your computer any time, and many lenders will give you a decision in as little as one business day.
How to Get an Affordable Auto Loan
There are lots of ways to obtain an affordable auto loan. Before you start applying for loans, review these tips to get the best loan terms for your financial situation.
Improve Your Credit
If your credit score is low, it might be smart to hold off on financing. Improving your credit will help you qualify for a lower interest rate, so you'll spend less overall. Here are some effective ways to boost your credit score:
Catch up on past-due accounts
Make on-time payments
Lower your credit utilization
Pay off as much debt as possible
As a best practice, you shouldn't accept the first loan offer you get. Shop around and compare lenders to see what loan terms you can get from different banks. Some lenders might also offer unique incentives. For instance, credit unions may offer military discounts for active duty personnel, veterans, and their families.
Before you head to the dealership, get a letter of pre-approval. A preapproval is an offer letter from the lender that includes your loan terms, like your interest rate and loan period.
Just because you get preapproved doesn't mean you have to borrow the money. A preapproval letter can help you negotiate better loan terms from a different lender, especially one that works with the dealership you're visiting.
What Credit Score Do You Need to Finance a Car?
Every lending company has different credit score requirements for financing a car. However, you should aim for a credit score of 670 or above when you apply for a loan. The higher your credit score is, the more favorable your loan terms should be.
Does Financing a Car Mean You Own It?
You own a financed car in the sense that you're responsible for maintenance, taxes, and registration. However, the lender usually keeps the actual title while you pay off the loan.
And remember: the lender can repossess your car if you stop making payments. You don't have full legal ownership of the vehicle until the loan is paid off.
Are There Any Alternatives to an Auto Loan?
Paying cash is one of the most common alternatives to financing a car, but there are other options. For example, you might decide to lease a car for a few years. Leasing won't end in ownership (unless you buy the car at the end of the lease period), but it allows you to keep your monthly payments low. You might also consider peer-to-peer lending platforms to borrow money from individuals, which are usually unsecured and often have lower interest rates.
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