How to Finance a Car: 7 Steps to Get an Auto Loan

Buying a car outright is the fastest way to own a car. However, the option to pay in full is out of reach for many people — especially these days. U.S. Census Bureau data shows that only about 37.5% of U.S. households are earning over $100,000 per year.Meanwhile, the average new car costs about $50,000, according to CNBC.

With this tight math, it’s not surprising that financing a car can be a more manageable method for most consumers. But how does car financing work?

Put simply, when you finance a car, you borrow money from lenders to purchase a vehicle. Instead of paying the full purchase price upfront, you make regular payments to the lender, including interest, over a specified period. Then, when the term is done and you’ve made all of your payments, the car is officially yours.

While this process may seem straightforward, there are several critical things to know about car financing— and where it can go wrong. This article covers what you should know about buying vehicles with financing, including how to get a car loan, common loan terms, tips and car financing FAQs.

How Does Car Financing Work?

Car loans involve borrowing money to purchase a vehicle and then repaying that loan over time, typically with interest. Instead of paying the entire cost of a car up front, you take out a loan with a lender and pay a set amount each month.

In brief, when financing a car, you:

1. Start by applying for a loan through a bank, dealership, or other lender.
2. Get loan approval with terms such as the amount, interest rate, and repay period.
3. Make a down payment on the car, if required (the outstanding amount will be borrowed from the lender, i.e. covered by the loan).
4. Complete and execute loan documents to take out the loan.
5. Make monthly payments over the loan period.
6. Transfer the title to your name once the loan is paid off in full so that you officially own the car.

You can read more details about each of these steps in the sections below.

Auto Loan Terminology

Before jumping into the steps of how to finance a car, it’s helpful to first get to know the common terms you might hear when purchasing a vehicle. You may already be familiar with some, as many are used with other types of loans.

When financing a car, here are several key terms to know:

• Down payment: The amount of cash required up front that goes toward the car purchase price when taking out a loan. As a rule of thumb, Kelley Blue Book recommends putting down at least 20% of the car’s purchase price. Example: If your car costs $40,000, your down payment should be at least $8,000.

• Loan principal: The total amount of money you borrow from the lender to purchase the car. Example: If your car costs $40,000 and you make a down payment of $8,000, your loan principal is $32,000.
• Interest rate: The basic percentage the lender charges each year for the amount of money you borrow over the loan term, which you’ll pay in addition to the monthly payment. The interest rate you’re offered often varies based on your credit score.
• APR (Annual Percentage Rate): The total annual cost of borrowing the money, including the interest rate and any additional fees associated with the loan.
• Loan term: The length of time (usually in months) you have to repay the loan in full. The lender and borrower agree on a term in the loan contract.
• Monthly payment: The fixed amount you pay the lender each month to cover the principal and interest on the loan. This is also sometimes referred to as a “car note".
• Origination fee: A fee the lender charges to process and set up your car loan.
• Car title: An official document from the state that contains the car’s make, model, year, unique vehicle identification number (VIN) and the owner’s information.

How to Get a Car Loan in 7 Steps

Once you’re familiar with key terms, you’ll have a better idea of what to expect when applying for a car loan. Your credit health, however, is an important factor in the financing process — especially when it comes to potential auto loan interest rates.

The following steps may help you secure a car loan that works for your financial situation.

1. Determine Your Budget

The first step is to figure out how much you can afford to pay for monthly car payments. Create a budget and compare your total monthly income to your monthly expenses. Then, see how much money you can realistically spare for both one-time car purchase expenses and monthly payments.

Keep in mind that the cost of having a car goes beyond just the loan payment. Consider other car-related expenses, which can include things like:

• Taxes and fees
• Registration
• Gas
• Insurance
• Maintenance (oil changes, new tires, etc.)
• Tolls, parking passes and tickets

2. Know your important ratios

When you try to apply for a car loan, the lender will assess your financial situation in a number of ways. Two metrics they will almost certainly review are “Debt-to-Income Ratio” and your “Payment-to-Income Ratio”.

Understanding these ratios can help you gauge your financial readiness for a car loan and ensure you don't overextend yourself. Keeping both ratios within recommended limits can lead to better loan terms and a smoother approval process.

Debt-to-Income Ratio (DTI): This metric compares how much debt you have to how much money you make. Lenders use DTI to assess your ability to manage additional debt. A lower DTI indicates better financial health that would allow you to responsibly take on more debt and increases your chances of loan approval with favorable terms.

You can calculate this yourself by dividing your total monthly debt payments by your gross monthly income. Most lenders prefer a DTI of 36% or lower to demonstrate borrowers can handle additional debt.

How to Improve Your Credit Health

Achieving good credit can’t be done overnight. The key is to establish good credit habits and to be consistent.

Some things you can do to work on your credit include:

• Check your credit to find and fix your problem areas
• Correct any errors or inaccuracies on your credit reports
• Make on-time payments to keep your credit score in good shape
• Maintain a low credit utilization ratio, ideally under 30%
• Avoid applying for many types of credit in a short time, which can hurt your score

4. Research Car Financing Options

Once you have an idea of your credit health, shop around for car loans from multiple lenders. The following are different types of lenders and financing options for a car:

• Bank loans
• Dealership financing
• Credit unions
• Online lenders
• Special financing programs

Each one might offer their own benefits and drawbacks, so it’s important to figure out what kind of lender or loan might work best for you.

Comparing Loan Terms: Interest Rates, Duration and Other Requirements

When comparing finance options, there are a few loan terms that might vary between lenders. For each lender, look into the following:

Interest Rates: Shop around for the best (lowest) interest rates. Your credit score will significantly impact the rate you’re offered. For example, depending on your credit score, your loan interest rate could range from 5% to 20% — a major difference in cost.

You can save a lot of money by getting a lower interest on your car loan. Let’s look at a hypothetical example of how your monthly payment and total interest paid are impacted by the loan interest rate.

If you financed a new car with a $25,000 loan for 60 months, you might pay:

Getting a lower interest rate is almost like getting a discount on your car because you pay less money on your monthly payment and total interest costs on the loan. For example, comparing the difference between a 11% interest rate and 20% interest rate, you could expect to save over $7,000 in interest on this loan amount.

Loan duration: Shorter loan terms typically have higher monthly payments but lower overall interest costs. Longer terms may be more manageable monthly but can cost more in interest over time.

Other loan requirements: In addition to interest rates and loan duration, ask your lender about any loan requirements, especially if you are considering buying a used car or from a private seller (if you want to buy from an individual). These requirements can vary widely between lenders and may significantly impact your eligibility and the overall cost of the loan. Some requirements may include:

• Vehicle age and mileage limits-Vehicle inspection or appraisal
• Minimum and maximum loan amounts
• Clear title (no liens)

Leasing vs. Traditional Financing

In addition to comparing loan options, it’s also worth considering whether leasing a car might be a better fit for your needs than buying one through traditional financing.When youlease, you’re basically renting the car for a few years. You make monthly payments, but you don’t own the car. At the end of the lease, you return it or buy it.

Here are some leasing vs financing differences to consider:

• Ownership: With a loan, you own the car once it’s paid off. With a lease, you return the car at the end of the term unless you choose to buy it.
• Monthly Payments: Lease payments could be lower than loan payments, particularly if you get a special lease deal.
• Mileage Limits: Leases typically come with annual mileage limits (e.g., 10,000–15,000 miles). Exceeding these limits can result in additional fees.
• Wear and Tear: You may be charged for excessive wear and tear when returning a leased vehicle.
• Flexibility: Leasing allows you to drive a new car every few years, while financing is better if you plan to keep the car long-term.

5. Get Pre-Approved for a Car Loan

After narrowing down your lender choices, you can apply for loans with them to get “pre-approved.” Pre-approval means a lender looks at your financial information and gives you an estimate of how much money they’re willing to lend you. It’s not a final offer, but it gives you a good idea of what you can afford.

Loan pre-approval lets you see what loans you are likely to qualify for but typically requires a hard inquiry with the application. A “hard inquiry” (also called a “hard pull”) may temporarily lower your credit score.

A big benefit of getting pre-approved is that it can give yousome more negotiating leverage. When you walk into a dealership with a pre-approved loan, you’re basically acash buyer. This means:

• You canfocus on getting the best pricefor the car, not just the monthly payment.
• You areless likely to accept upsells or unnecessary add-ons and stick to your budget.
• You cancompare dealer financing to your pre-approval and choose the better deal.

To get pre-approved, you’ll likely need to provide the following to a lender:

• Proof of income and employment
• Personal information, like your full name, birthdate, and Social Security Number
• Proof of address and insurance
• Information about the car you want to buy (VIN, make, model, year, mileage, etc.)

Keep in mind that loan rate shopping can impact your credit score since pre-approval requires a lender to perform a hard credit pull. But you can reduce the impact by applying to different lenders within a short amount of time. Note that credit scoring companies treat these checks differently. VantageScore® counts all loan applications made within 14 days as just one inquiry. FICO® gives you more time—up to 45 days. By keeping your applications within these time frames, you can shop around for the best loan rates without significantly hurting your credit score.

6. Pick Out Your Car

With financing offers or loan pre-approval, you can find a car that fits your budget. Visit dealerships and private sellers to look at your car options in person. This allows you to better analyze the conditions of the cars, especially if some are used vehicles.

A dealership may give you a better offer than the other lenders if you choose to finance through them directly. Also, many auto lenders give you 30 days to decide whether to accept their loan offer after getting approved. Choose a car and negotiate with the seller or dealer on the final price.

7. Select Financing and Purchase Your Car

After agreeing on the car’s final price, contact your lender to share the details. Make sure the loan you choose will cover the type of car you’re getting, as some lenders won’t accept certain models.

Your lender will handle the paperwork and finalize your financing contract for you to review and sign. The contract will outline details such as your:

• Interest rate
• Monthly payment
• Repayment schedule
• Other conditions

Before signing, make sure you fully understand the terms and their impact on your finances, review the contract thoroughly, and confirm there are no hidden or unexpected fees.

Once you sign and send in the paperwork, your lender will disburse the funds for you to purchase the car.

Pros and Cons of Car Financing

When financing any type of large purchase, there are advantages and disadvantages. Here are a few things to consider with car financing:

Final Lap: Gear Up Your Car Financing Prep

In summary, securing a good auto loan requires careful planning and research. If you show up to the dealership unprepared, you may not leave with what you want. The right loan not only saves you money but also enhances your overall experience. Take your time, compare your options, and drive away with confidence, knowing you've made a smart choice.

Final reminders:

• Build your budget to be clear on what you can actually afford and focus on the total loan amount rather than the monthly payment amount to avoid higher total interest costs.

• Review your credit report and score because your financial history plays a significant role in loan approval. Consider monitoring your credit ahead of time.

• Lower your DTI and PTI because auto lenders will likely consider these ratios as part of their loan-making process.

• Compare car loan interest rates from different lenders. They may assess credit risk differently, and this means the interest rates you receive can vary significantly. To protect your credit score, try to submit all loan applications within a short time frame as credit scoring models typically treat multiple inquiries in a short period as a single event.

• Wait to close accounts because doing so can increase your credit utilization and potentially lower your credit score.
• Avoid applying for other kinds of new credit before buying a car because it likely will result in a hard inquiry, which can also lower your credit score.

These approaches can help put you into a better position when it’s time to finance a car, and boost your overall financial health, as well.