How Does Financing a Car Work?

If you need a vehicle but want to pay monthly rather than hand over a lump sum of cash, then looking into car financing options can help you out. You can obtain auto loans through financial institutions as well as dealerships, and several factors determine whether you qualify, how expensive of a car you can purchase and how much interest you'll have to pay to borrow the money. To get a better idea of how financing a car works, you can learn important terminology for car loans, the pros and cons of different options and the specific steps involved in researching, applying for and managing car loans.

Car financing compares to other types of financing, such as mortgages, in that you're taking on a debt for a major purchase that you might not be able to afford if you had to pay the full amount in cash at once. You might instead make a reasonable down payment to bring down the total amount of money you need to borrow and show the lender you're serious about the loan. However, this might not be necessary if you have good credit and a sizable, stable income.

It's important to know that car loans differ from unsecured debts like credit cards. While your credit card company won't use one of your possessions as collateral and take it away if you miss a payment, a vehicle lender puts their name on your car's title so they have a claim on your car until you've met your obligations for the loan. Vehicle repossession can happen after you've missed payments and haven't made any alternate arrangements with your lender.

Regardless of where you obtain your financing, your lender gives you a monthly due date for your car payments. You have to continue making them until the whole amount has been paid off along the interest to cover the cost of borrowing. Due to this added cost over the car's price for using financing, it's possible to end up owing more than the car's value, especially when you factor in depreciation for new cars. So, it's important to consider how the interest adds up over time before you agree to buying a vehicle with a loan.

​Read More​: How to Buy a Car

When looking into financing a car, you'll see some common terminology when it comes to the loan itself and your car payment. It's important to understand these words before you agree to any financing option:

• ​Principal​: The principal portion of your car loan refers to the money borrowed for the vehicle you purchased. It often won't be equal to the car price since you could have made a down payment or applied the trade-in value of an old vehicle to the purchase amount, and you might also have fees and taxes wrapped up in the loan. As you make car payments, you will pay off a small amount of the principal at a time alongside the interest charged based on your loan principal.
  

• ​Interest​: Borrowing money for a car usually doesn't come free unless you end up buying a car subject to a special financing deal without interest. Instead, you can expect to pay simple interest on the car loan principal with every monthly payment. This means you usually don't deal with compounding interest like with other types of loans. The lender sets your annual percentage rate based on market rates, your credit score and sometimes markup if you're dealing with dealer financing. Generally, expect the best interest rates if you shop around and have a good credit profile and the worst ones if you have poor credit and need to seek in-house financing at a dealership.

• ​Term​: This refers to the length of time you'll make monthly car payments to pay off the loan, and you often have a choice in how long you'd like to have. Usually, the loan term ranges between ​two and seven years​ (​24 to 84 months​), with longer terms usually having a higher interest rate than shorter ones. You can usually request a payoff amount from the lender to make a lump sum payment and finish off the loan early. However, prepayment penalties may apply, so you should check your loan contract before doing so.
  

When you reach out to financial institutions like banks and inquire about an auto loan, then you're seeking direct financing since you don't have a dealership doing that work for you when you go to buy a car. Often, you'll start the process of seeking direct financing before heading to a car lot. You can check with a few different lenders, see the loan terms they're willing to offer you and choose to proceed with the one that looks the most favorable to you. You can get preapproval before you head to the dealership, and then finish the application process when you've chosen a car to buy.

Direct financing requires some work on your part as well as thorough research so you get the best deal. However, you can get benefits like a lower interest rate and the ability to borrow through a financial institution where you already do business. Your chosen bank might also offer perks like rewards for making timely payments.

In contrast to doing the research yourself, dealer-arranged financing involves letting the car dealer look for loan options for you through the financial institutions that work with the dealership. Usually, this happens after you've found a car and want to move forward with buying it. The dealership will then ask for some information such as your current income, preferred loan term and expected loan amount.

After you've provided enough information, the dealership can submit some requests to see what you can get approved for and then have you select the option with the terms you like. There may be some markup in your interest rate with this method to compensate your dealership for arranging the financing for you. Therefore, it's usually a good idea to negotiate so that you can reduce the markup as much as possible.

This financing option comes with convenience and can be helpful if you'd rather not reach out to lenders on your own and analyze multiple options. However, the tradeoff is often a slightly higher interest rate and the lack of variety in lender options. In some cases, though, going with dealer-arranged financing may lead to good deals if you're eligible for a manufacturer's financing promotion.

If you've ever driven by used car lots, you might have noticed some of them advertising "buy here, pay here" financing. This means that the dealership, rather than an affiliated bank, acts as a direct lender that extends auto loans to people who might not have established their credit or who might have issues like low credit scores or bankruptcies. When you step into this type of dealership, they ask about your finances and determine the car loan you could get. You can then use that information to pick a used vehicle on the lot you can afford and finalize the deal.

People who can't get a loan through other sources and don't have the cash to buy a car outright can benefit from in-house financing as a last resort method for getting a used vehicle. The main downside is that interest rates can get very high and even reach ​20 percent​ for these loans. In-house auto loans tend to have high default rates, so dealerships usually not only charge high interest rates but also use devices that can make it easier to get the car back through repossession.

Depending on the specific type of financing and lender, you may encounter the following requirements for getting an auto loan:

• ​Vehicle restrictions​: Whether you're using in-house financing or a direct lender, you can experience restrictions such as whether you can buy a used or new vehicle and which criteria cars must meet. For example, you usually have to use in-house financing only for used cars on the specific lot, and this can be a problem if you want a new car. A bank or credit union might not finance cars below a certain value or over a certain number of miles or age. You also might not get to use a car loan for a private party car sale.

• ​Income and employment​: You need some form of income to get a car loan, and lenders usually look for stable employment and enough regular income to cover your monthly auto loan payment alongside your other bills. Particularly, you can encounter strict minimum income requirements when you're trying to get in-house financing. For example, some may require ​$2,000 a month​ in income from one job and not accept funds from side jobs or sources like Social Security. This can be frustrating since these requirements may not be waived even if you have no other debts to pay.

• ​Credit score​: To avoid needing to look for bad credit loans or locating a person to be a co-signer, your credit history must show a credit that is at least in the good range that tends to start in the ​upper 600s​. Having a high debt load or credit report blemishes like defaulted accounts can mean a lower credit score and higher interest rate or even difficulty getting approved.
  

• ​Debt-to-income ratios​: Lenders consider your monthly debts divided by monthly income to assess your ability to handle a car loan. The ideal maximum debt-to-income ratio is ​45 to 50 percent​, and your car payment usually shouldn't cost more than ​20 percent​ of what you earn every month.

• ​Additional requirements​: As a borrower, you need to be ​18 or older​, have proof of the address where you plan to keep the car parked and possess a valid ID with your photo on it.
  

​Read More​: What Is Co-Signing a Car Loan?

Once you've decided on the type of car financing to use, your next steps depend on your choice.

• ​Direct financing​: If you're going with direct financing through a credit union or bank, you need to submit some information for preapproval and receive a document showing the loan offer so you can present it at the dealership. Your financial institution's website likely has a preapproval form that provides you with a response and proof pretty quickly, but you can also get help in person or over the phone. When you're at the dealership and want to buy a specific car, your lender may have you go to the bank to complete your final paperwork or do it online. Your dealer may hand the car over to you while the final financing paperwork is being completed, but the Consumer Financial Protection Bureau warns this is risky in case your loan falls through.
  

• ​Dealer financing​: If you're pursuing dealer-arranged or in-house financing, you can just bring key documents like residency, income and identification documents with you since the dealership will ask questions and handle your application. You might complete the application before finding a car if you're using in-house financing; otherwise, you handle the application and paperwork once you've chosen a vehicle. In any case, pay attention to the loan terms presented, and don't hesitate to negotiate a lower rate or even walk away if the cost of borrowing seems too high for your comfort.
  

Finishing your auto financing application means you'll need to start making regular monthly payments and potentially find ways to reduce the interest you pay. Staying on top of payments and requesting help, like payment deferment in emergencies, can help keep your credit in good shape and reduce the risk of repossession and fees. To lower the total cost for your financed car, you could contact your lender to make extra payments to your car loan's principal or consider refinancing for better terms.

​Read More​: What Happens If You Miss a Car Payment?