How Car Finance Works?

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Buying a car is a big financial investment, even if you are buying a used model. To make costs more manageable, many drivers choose to finance their cars with car loans. When you finance a vehicle, you pay for the car in monthly installments, not a lump sum.

While car loans can help you buy a car more easily, there are also some downsides to consider. In this article, we’ll explain everything you need to know about car financing, 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 buy a vehicle with money loaned to you by a financial institution, such as a bank. You can finance the entire cost of the vehicle, or pay a down payment using cash, and finance the remainder of the purchase. You pay off the loan in monthly installments, plus interest, over a predetermined period of time.

Most car loans are guaranteed, meaning your car is used as collateral. If you stop making loan payments, the lender has the right to take the car back and sell it to get their money back. Even if you technically own the car being financed (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 Car Loans

Car loans may seem complicated, but they are actually quite easy. Here are some car loan terms that you should know before you apply for a loan.

Down payment

The down payment is the amount of money you put on the car. Lenders usually favor borrowers paying down payments on their vehicles, because it shows they are committed to the loan.

Since you can’t borrow a cash advance (it has to be done with cash you already have), putting more money under the car can help you get better loan terms, such as lower interest rates.

Annual Percentage Rate (APR)

The annual percentage rate (APR) is basically the cost of borrowing money. When you apply for a loan, the lender gives you an APR based on your credit score, which determines your creditworthiness. For example, if you have bad credit, lenders may perceive you as more likely to default on your loan and charge a higher APR to reduce risk. Lenders tend to select drivers with good credit scores, which helps you qualify for a lower APR.

Loan Term

The term of the loan is the period of time you have to repay the money you borrowed. Typical loan terms range from 36 to 72 months, but some lenders allow you to borrow money for both shorter and longer terms.

Choosing a longer loan term allows you to pay off your car slowly, but it also means you’ll be paying more in interest. If you can afford to spend more on your monthly car payment, consider choosing a shorter loan term. You’ll pay less in interest and you’ll build equity in the car faster.

Advantages of Car Financing

Financing a car can be a smart financial move for many people. Here are some of the advantages of getting a car loan.

Immediate Funding

Saving enough money to pay cash for a vehicle can take years. With financing, you can get money quickly. Even if you go to a local dealer without getting a loan beforehand, you can apply for a loan, get funding, and drive away with a new car the same day.

Eventual Ownership

If you’re shopping for a car on a budget, you might also consider renting. But with a financed car, you end up owning the car outright. You can choose to keep the car for years or sell it and use the money to buy the next vehicle.

Build Equity in Cars

When you finance a car, you are still building equity in your car over time. At some point during the life of the loan, you will end up owning a larger percentage of the car’s value than you still owe. In comparison, when you rent a car, you never build equity in the vehicle.

Credit Enhancement

Another benefit of car financing is that it can improve your credit score. Making your monthly payments on time shows credit reporting agencies that you are a reliable borrower. By building your credit score now, you can potentially get more favorable loan terms in the future.

Disadvantages of Car Financing

While car financing is a popular option, there are some downsides to consider. Here are some things to know before you choose to get a car loan.

Higher Cost

One of the biggest downsides to financing a car is the cost. Regardless of what APR you get, you will end up paying more than the car is worth over the term of the loan. You can avoid interest rates and other fees by paying cash for your new or used car.

Limited Vehicle Selection

If you have your heart set on a certain type of vehicle, financing may not be the right choice. Some financial institutions only provide loans for certain types of purchases. For example, a bank may not give you a loan to buy a car that is more than 10 years old.

Insurance Requirements

To reduce risk, lenders often require borrowers to have a full coverage auto insurance policy for the life of the loan. Full coverage policies include comprehensive coverage and collision coverage that pays for repairs to your vehicle if you cause an accident. These policies are more expensive than minimum coverage policies, which provide only the minimum amount of coverage required in your state.

Where Can You Get Car Finance?

Many financial institutions provide car loans. Here are some places to look if you’re thinking about applying for a loan.

Credit Union

Credit unions are non-profit organizations that offer banking and loan services. If you have good credit, getting a loan from a credit union can help you get a lower APR. In general, the main goal of credit unions is to serve their members rather than make the most profit, so it’s worth researching local credit unions to see what your options are.


If you have a relationship with a bank, see if they offer auto loans. Although car loans from banks sometimes have stricter terms and higher interest rates, you may get a better deal if you are already a customer and have sufficient funds in your bank account.


Auto dealers work with a network of lenders to offer car loans to car buyers on the spot. These lenders tend to charge the highest interest rates, but they’re a convenient option if you don’t have time to get a loan before you start shopping for a car. If you have bad credit, a dealer lender may be willing to work with you to close a sale.

Online Auto Financing vs. Individual

There are several ways to get a car loan. You can visit a bank or credit union in person, which can give you the most leverage for a favorable APR. You can also apply for a loan at a dealer through one of their lenders. Applying for car finance online is probably the easiest option. You can apply from your computer at any time, and many lenders will give you a decision in just one business day.

How To Get Affordable Car Loans

There are many ways to get an affordable car loan. Before you start applying for a loan, review these tips for getting the best loan terms for your financial situation.

Increase Your Credit

If your credit score is low, it may be smart to hold off on financing. Improving your credit will help you qualify for lower interest rates, so you’ll spend less overall. Here are some effective ways to improve your credit score:

  • Pursuing overdue accounts
  • Make payments on time
  • Lower your credit usage
  • Pay off as much debt as possible

Have a look

As a best practice, you should never 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 may also offer unique incentives. For example, a credit union may offer military discounts to active duty personnel, veterans, and their families.

Get Preapproved

Before you go to the dealer, get a pre-approval letter. A pre-approval is a letter of offer from a lender that includes your loan terms, such as your interest rate and loan period.

Just because you get a pre-approval doesn’t mean you have to borrow money. A pre-approval letter can help you negotiate better loan terms from different lenders, especially those that work with the dealer you visit.


What Credit Score Do You Need to Finance a Car?

Each lending company has different credit score requirements to finance a car. However, you should aim for a credit score of 670 or more when you apply for a loan. The higher your credit score, the more favorable your loan terms will be.

Does Financing a Car Mean You Own It?

You own the car financed in the sense that you are responsible for maintenance, taxes and registration. However, lenders usually keep the actual title when you pay off the loan.

And remember: the lender can repossess your car if you stop making payments. You do not have full legal ownership of the vehicle until the loan is repaid.

Are There Alternatives to Auto Loans?

Paying cash is one of the most common alternatives to car financing, but there are other options. For example, you might decide to rent a car for a number of years. Leasing doesn’t end in ownership (unless you buy the car at the end of the lease), but it allows you to keep your monthly payments low. You can also consider peer-to-peer lending platforms to borrow money from individuals, which are usually unsecured and often have lower interest rates.

Headshot of Elizabeth Rivelli

Finance & Insurance Editor

Elizabeth Rivelli is a freelance writer with over three years experience in finance and personal insurance. He has extensive knowledge of various lines of insurance, including auto insurance and property insurance. His byline has appeared in dozens of online financial publications, such as The Balance, Investopedia,, Forbes and Bankrate.

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