Understanding Car Financing

Generally, most people don't purchase vehicles outright; they finance them, meaning, they get a loan from one of a variety of lenders and pay off that loan over a designated period of time.

Auto Loan Basics

Financing a new or used vehicle with a dealership, bank, or credit union is common (skip down to Auto Loan Financing Options for more details), but exactly what goes into determining your car loan?

Simply put, you can expect potential lenders to look at:

Your credit score—People with higher credit scores are more likely to get better auto loans (or, in some cases, get auto loans at all).
Your ratio of debt to income—Your debt-to-income ratio is how much money you owe in debt compared to the amount of money you earn.
The size of the loan and the down payment—Typically, a larger down payment lowers the size of the loan, and helps you get lower loan payments, too.
The length of the loan—For how many months do you want to finance your vehicle? This can determine the amount of your monthly vehicle payments.
The age of the vehicle—Often, you're more likely to get a better auto loan rate for a new vehicle than you are for a used one; this is because if you default on the loan for a new vehicle, it will still have a higher resale value.

Auto Loan Financing Options

Many buyers—especially those purchasing their first vehicle from an auto dealer—believe getting a loan with the dealership is their only option; while this is a common option, it isn't the only one.

Below are several ways buyers can obtain car loans, along with a few of the advantages and disadvantages of working with each type of auto lender.

Dealerships

Again, it's common to finance a vehicle with the help of a dealership; in fact, it's probably the most convenient option. Once you decide on a vehicle, you can both buy and finance it in one day.

Your dealer will arrange all of your auto loan financing requirements for you. Plus, you might get better financing rates than you would with another lender if the dealership is trying to get rid of its end-of-the-year inventory.

However, “convenient" doesn't always mean “best"—at least not for all buyers. For example, financing a vehicle with a dealership sometimes means more expensive interest rates (especially if you have a less-than-stellar credit score), additional and often unnecessary fees, and working with third-party lenders with whom you don't already have a relationship.

Manufacturers

Generally, getting a car loan through a vehicle manufacturer means working with the dealership to take advantage of special financing deals offered by the manufacturer itself and not the dealership. Sometimes, you'll see commercials and other advertisements for manufacturer financing offers, or your car salesperson will tell you about them. Of course, it's always wise to ask about these offers, too.

Although manufacturer financing deals can get you low financing rates, they're usually only available to people with excellent credit scores.

Banks

For many, getting a car finance loan from a bank is the best option—especially if you work with a bank with which you already have a relationship. Getting a bank auto loan means you'll already know how much you can afford before you start shopping for your car. Oftentimes, a bank can negotiate lower interest rates and shorter loan terms.

Perhaps the only downside to getting auto loans from banks is having to make the extra trip before visiting the car dealership; however, if you can get better loan and interest rates, it may be worth it.

Credit Unions

Working with a credit union is similar to working with a bank; in fact, some people use credit unions for all their banking needs. Just like working with banks, getting an auto loan from a credit union means you know your financial terms and conditions upfront, before you even step foot on the car lot.

However, even though credit unions generally offer lower loan rates than do banks, there are occasions when credit union interests rates may be higher. Be sure you fully understand the loan interest you'll have to pay before you sign the dotted line.

Online Auto Financing

Online auto financing is becoming increasingly popular. Similar to working with your bank or credit union, working with an online auto financing company can help you do everything from completing the car loan application to getting pre-approved for your loan. Plus, because it generally costs less to do business online, online finance companies might offer even lower rates than traditional banks and credit unions.

Getting Pre-Approved Car Loans

Car loans with dealerships or manufacturers take place at the dealership, generally after you've decided on a vehicle. Working with a dealership or manufacturer can puts you on the spot, leaving room for finding out your interest rates are too high, your credit score isn't up to par, or worse, you don't qualify for a loan at all.

Getting a pre-approved car loan is beneficial because you walk onto the car lot knowing exactly how much money you can afford to spend, making it much easier to shop within your budget. You've already been approved for the loan, and you know the exact terms and conditions of the loan.