What Does Financing a Car Mean and How Does It Work?

Buying a car with cash can be quite challenging, which is why financing a car purchase is so common. When you finance a car, you make a down payment and then take out an auto loan that allows you to pay off the vehicle over a set period of time. You’ll make monthly payments, with interest.

You’ll want to keep a few factors in mind, including the loan term, any fees, and the monthly payment amount.

How does financing a car work?

When you finance a car, a car dealership, lender, or other financial institution loans you money to buy the vehicle. You can take out an auto loan that’s specifically designed for car purchases, or you can take out a traditional personal loan and then use those funds to buy a car. In return, you’ll repay the money you borrow (plus interest) over a set period of time, known as the loan term.

While it’s possible to secure vehicle financing without a down payment, some lenders may require one to approve you for an auto loan. Even if a down payment isn’t required, it’s still a good idea to make one: The larger your down payment, the less money you need to borrow and the sooner you can repay your auto loan. A good rule of thumb is to make a 20% down payment if you’re buying a new car and a 10% down payment for a used-car purchase.

Your monthly auto loan payment will consist of two parts:

• Principal: This is the original loan balance.
• Interest: This is the cost of borrowing money. Lower interest rates cost less money over the life of the loan.

Factors that affect auto financing

Not all auto loans are the same, and you’ll need to shop around to find the best car financing option for you. Keep these things in mind to make sure you find the best auto loan for your situation:

• Annual percentage rate (APR): A loan's APR represents both the interest rate for the loan and any upfront fees or charges required to take out the loan. Even if one loan has a lower interest rate than another loan, it’s important to compare the APR of each loan to see which one will truly cost more money.
• Fees: Auto loans can come with fees relating to an extended warranty, vehicle service contract, maintenance, or other add-ons. Compare how much in fees you stand to pay with each lender you’re considering.
• Terms: How long you have to pay back your auto loan can affect the size of your monthly payment and the overall cost of your loan. While it may seem like a longer loan with lower monthly payments is a better deal, going the longer route will result in paying more interest over time. Shorter loan terms come with higher monthly payments, but you’ll pay less interest overall and lenders tend to offer lower interest rates for shorter-term loans.

Once you find an auto loan that meets your needs, you can apply for the loan.

How is my monthly payment determined?

Your monthly auto loan payment amount depends on multiple factors, starting with the car’s purchase price (minus any down payment or trade-in amount) and whether the car you’re buying is new or used.

These factors also affect your monthly payment amount:

• Loan amount: The size of your loan is the biggest factor that determines your monthly payment amount. For example, buying a brand-new luxury SUV will result in a much higher monthly payment than buying a used mid-priced sedan.
• Loan term: The longer your loan repayment term, the smaller your monthly payments will be, but the more you’ll pay in interest. Smaller loan terms come with higher monthly payments. But you’ll pay less money in interest since you make fewer monthly payments overall, and lenders typically charge less interest for shorter-term loans.
• Credit score: Your credit score affects the interest rate a lender will offer you when you apply for a loan. Your credit score indicates to a lender how likely you are to repay your loan. So the higher your credit score is, the lower your interest rate is likely to be.
• Income: Lenders also consider your income when determining your interest rate. They'll look at your debt-to-income (DTI) ratio, which is the percentage of your gross monthly income that goes toward debt payments. The lower your DTI, the better your chances of securing a lower interest rate and monthly payment.

What are my auto financing options?

When it’s time to pursue auto financing, you have a few options:

• Car dealerships: Most car dealerships can help you find auto financing through an outside lender. This may cost more than applying for a loan yourself, as the dealership wants to be compensated for the work they did to find you a loan. Some dealers also offer in-house financing, known as "buy-here, pay-here" financing. This type of financing is designed for those with bad credit. It can be appealing since these lenders often won’t check your credit when you apply for a loan. But these auto loans can have very high down payment requirements and interest rates.
• Banks and credit unions: If you know how much you’re hoping to spend on a car, you can go to your bank or credit union to apply for an auto loan or a personal loan. Some banks and credit unions will let you get prequalified for a loan before you officially apply, which will give you an idea of how much they might lend you. This can make car-shopping easier. (Note that if you officially apply and are approved you may receive a different interest rate than the one in your prequalification offer.)
• Online lenders: Online auto lenders offer auto loans — as well as personal loans that you can use to buy a car — if you don’t want to go with a traditional bank or financial institution. Many online lenders also allow you to apply for prequalification prior to submitting a formal loan application.

If you’re looking for a personal loan to buy a car, Credible makes it easy to see your prequalified personal loan rates from multiple lenders, all in one place.

What credit score do I need to finance a car?

While you can get an auto lower with bad credit, generally, the higher your credit score is the easier it is to qualify for a lower interest rate. All lenders have different credit score requirements, and it's possible for almost anyone to secure a car loan. But if you have a low credit score you can end up with a high APR, and you may need a cosigner with good credit to help you qualify.

The table below shows average interest rates for new and used cars based on borrowers’ credit score ranges as of the first quarter of 2020:

Here’s an example of how your interest rate can affect how much you pay to finance a car.

Let’s say you have a super prime credit score and want to buy a new car. If you qualify for a 3.65% interest rate on a five-year, $25,000 loan, you’d pay $27,388 over those five years.

But if you have deep subprime credit and paid a 14.39% interest rate on the same loan amount and term, you’d end up paying $35,206 over the life of the loan — that’s $7,818 more in interest.

If you’re thinking about using a traditional personal loan to finance your car purchase, use our personal loan calculator below to get an idea of how much interest you might pay based on your credit score. Simply enter the loan amount, interest rate, and loan term to see how much you’ll pay over the life of the loan. You won't need a down payment, and the car will likely not be collateral on the loan. But the rate is likely to be higher.

Financing a car with poor credit

If you have poor credit, it’s still possible to get approved for a car loan, but your interest rate will likely be higher than someone with good or excellent credit.

If you’re struggling to qualify for an auto loan at a manageable interest rate, you can apply with a cosigner who has a good credit score and history. When you apply with a cosigner, the lender will take both your credit score and the cosigner's credit score into consideration. But keep in mind that if you fail to make your auto loan payments then your cosigner will be on the hook for them. If both of you fail to make the payments then both your credit scores will be negatively affected. Before someone agrees to cosign a loan, they should be aware of what the agreement entails and what their risks are.

You can also spend some time improving your credit score before you apply for an auto loan to better your odds of being offered a more favorable interest rate. If you’re working on your credit, these things can help you boost your score:

• Make on-time payments. Your payment history is the biggest factor that determines your credit score. Set up automatic payments or electronic reminders on any loan or credit card payments to make sure you never miss a payment.
• Lower your credit utilization ratio. If you can keep the amount of your available credit you’re using to below 30%, you can help your credit score improve.
• Minimize hard inquiries. In the months leading up to applying for an auto loan, try to limit the amount of new credit products that you apply for so that you don’t have recent hard inquiries on your credit report.
• Fix mistakes on your credit reports. Review your credit reports carefully for any errors that could be hurting your score. You can dispute any mistakes you find with the appropriate credit bureau. If they’re removed, it can help improve your score.

The personal loan companies in the table below compete for your business through Credible. You can request rates from all these partner lenders by filling out just one form (instead of one form for each) and without affecting your credit score.

Is financing a car a good idea?

Whether or not financing a car is a good idea depends on your unique situation. No matter what your finances look like, it’s always a good idea to shop around for the best deal when pursuing financing. Comparing interest rates, loan terms, and fees for multiple lenders will help ensure that you find a loan that best meets your auto financing needs.

Credible makes it easy to compare your personal loan options. You can see your prequalified rates from multiple lenders in two minutes — without affecting your credit.