For most people, a car is a significant investment. To fund the purchase of a new car, you might decide to borrow money in the form of an auto loan. A car loan allows you to borrow money from a lender to buy your car and pay it back (plus interest) over a fixed period.
Figuring out your financing isn’t the most exciting part of getting a new or used car, but it’s important to understand your options before you start car shopping. We’ll help you learn the basics of car loans, including where to look for a loan and how to apply.
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Car Loan Terms to Know
Before we dive into the process of applying for a car loan, let’s review some of the terminology you’ll probably come across.
The APR, or annual percentage rate, represents the interest rate of your loan, plus required fees.
APR is not the exact same thing as the interest rate, which is the cost of borrowing the money. Usually, the APR is a higher percentage than the loan interest rate.
A down payment is the amount of money you pay out-of-pocket when you purchase a new or used car. In many cases, people pay a certain percentage of the car’s value upfront, with the remaining balance covered by the loan.
Say, for instance, you’re buying a car that costs $35,000. If you pay $5,000 upfront as the down payment, you only need a loan for the remaining $30,000.
The down payment you make on a new car directly affects the amount of money you need to borrow and, subsequently, the total amount of interest you pay. You’ll almost always get better loan conditions when you put down a larger down payment.
When buying a car from a dealership, you’ll likely notice a few fees added to the overall cost of your vehicle. One of these is the documentation fee, which is what you pay the dealer to handle the paperwork and register the vehicle on your behalf.
The destination fee is the cost of getting the vehicle from the factory to the dealership. You might be able to get the dealership to waive this fee under certain conditions, but every dealership is different.
The loan term is the length of your loan. Loan terms typically range from 36 to 72 months, though some are as short as 12 months and others as long as 84 months.
For example, imagine the loan amount of $30,000 had a 36-month term. That means you’d have 36 months to pay back the $30,000, plus interest.
Because lenders take on more risk with longer loan terms, they tend to tack on higher interest rates. That $30,000 loan might have an interest rate of 4 percent at 36 months but a rate of 5 percent for a 60-month term.
In most cases, you’ll pay your loan back on a monthly basis. The monthly payment includes both the principal and interest. You must pay the lender consistently every month until the end of your loan term to avoid fees and other risks.
Longer loan terms have lower monthly payments, but you’ll pay more in interest overtime. For example, imagine taking out a loan of $30,000 at a 4 percent interest rate for a 36-month loan term. That would put your monthly payment at around $886.
That same loan over 60 months at a 5 percent interest rate, however, will leave you making a monthly payment of $566 per month. The interest rate is higher, meaning you’ll pay more overall by the end of the loan term, but the monthly payments themselves are lower.
Until you make your last monthly payment, the lender owns your vehicle and can take it from you if you miss loan payments. Once you’ve fully repaid the loan, the car is officially yours.
Where Should I Search for an Auto Loan?
Many financial institutions offer auto loans. If you have an existing relationship with a bank or credit union, start your search there. Otherwise, here are some places you can get an auto loan:
Banks or Credit Unions
Financial institutions such as banks and credit unions are popular options for drivers looking to get an auto loan. When you get your auto loan directly from a bank or credit union, you’ll already know how much you can borrow before you go car shopping.
Many online lenders, including online-only banks, issue auto loans. Loans from online lenders can be more convenient, with a digital application and same-day funding for some borrowers. Online lenders might also have more competitive interest rates than traditional banks or credit unions.
Car dealerships usually offer in-house financing for car shoppers. Many dealers make the process more appealing and affordable by offering special deals you might not get elsewhere. Plus, it can be easier to qualify for a loan at a dealership.
How to Get an Auto Loan
If you’ve never applied for an auto loan before, don’t be intimated by the process. Just be aware that it involves some upfront research and planning to find the best auto loan for your needs and budget. Here are the steps you should follow to get a car loan.
Set Your Budget
Before you start looking at lenders or shopping for cars, it’s a good idea to set a realistic budget. Otherwise, you might fall in love with a car, only to later find out that you can’t easily afford it.
The key to setting a proper budget is to determine your debt-to-income ratio. This ratio compares your gross income to your monthly debt expenses. Generally speaking, any ratio below 40 percent is good. Consider how a new car is going to affect that figure.
When setting your car budget, look beyond the sticker price of the car. Think about the cost of maintenance, gas, and insurance, which can add up quickly.
Check Your Credit
When you apply for an auto loan, the lender will check your credit, which is used to determine your interest rate. Checking your credit beforehand can give you a better idea of where you stand, and what type of loan terms you can expect.
Credit scores range from 300 to 850, with the best loan terms typically being available to those with a credit score of at least 800. Of course, that doesn’t mean someone with a credit score in the 700s can’t also get a good loan. It’s just important to recognize that, in most cases, people with higher credit scores get better loan conditions.
You can check your credit through any of the major credit bureaus, most of which offer online credit reports. Getting your own credit report isn’t considered a hard credit check in most cases, so you won’t have to worry about your score dropping.
Research Vehicles in Your Budget
Once you’ve confirmed your budget, start doing some research to see what types of vehicles you can afford. This will help narrow down your search. Be realistic about your vehicle needs. For example, if you really want an SUV but your budget only supports a sedan, don’t be tempted to purchase more car than you can realistically afford.
Choose Your Loan Term
Your car loan term is an important decision. Not only does the loan term affect your monthly payment, but it can also impact whether you have positive or negative equity in the car.
Negative equity is when you owe more on the car than what it’s worth. You’ll want to avoid this as much as possible. Remember that cars depreciate more over time. While your car still might have decent value at the end of a 36-month loan term, the value at the end of a 72-month loan term will be a fraction of that.
It’s typically safe to opt for a loan term of up to 60 months to avoid negative equity. You’ll still need to do some math and estimations to figure out exactly how it’ll work with your vehicle of choice.
With your budget and credit score in mind, it’s time to start looking for auto lenders. There are lots of financial institutions that offer loans, but it’s the interest rate that matters most.
Many lenders have a free online estimator that allows you to see your estimated interest rate for the amount of money you need to borrow, your self-reported credit score, and the loan term. Get quotes from a few different lenders to see which ones might be able to give you the best terms.
The next step after finding a few suitable lenders is to get preapproved. A preapproval represents how much the lender is willing to give you based on the initial information they’ve collected. However, a pre-approval isn’t a guarantee of financing or a certain interest rate.
There’s no harm in getting preapprovals from multiple lenders if you do so in a short period to avoid multiple hard credit checks. With these preapprovals in hand, you can easily tell which lenders will offer the best conditions for auto loans.
For your preapproval, the lender will need information such as your name, address, Social Security number, and phone number. They’ll also need proof of employment in most cases, which you can provide via W-2 forms or pay stubs. Additionally, some lenders will request the information about the vehicle you’re looking to buy, but it’s OK if you don’t have one picked out yet.
Keep in mind that a preapproval is typically only good for a month or two, so you won’t want to wait long to start looking for your next car.
Shop for a Car
At this point, you should already have an idea of what car you want. Now is the time to head to the dealership and start shopping for cars in-person.
Once you find a car you like and are ready to purchase it, negotiate with the dealer and arrive at a price that works for both of you. Then, you’ll want to secure the financing to complete the transaction.
Apply for the Loan
With your preapprovals in hand, figure out which lender has the best loan terms, and submit an application. But first, you’ll want to decide what down payment you will make on the car you’re buying, which will determine the amount you need to borrow.
Submit an application with the lender of your choosing, and wait to get approved. This can take as little as a few hours, or up to a few days, depending on the lender.
When you apply for a loan, the lender will probably run a hard credit check. This will cause your credit score to drop slightly, but your score should rebound quickly.
Buy the Car
The final step is to use the loan funds to pay for your vehicle.
Depending on the lender you choose, you might be able to apply and have the funds deposited in your account on the same day. Once you have the money in your account (or in the form of a check), you’re ready to complete the sale with the dealership.
If you’re getting financing through the dealership, the process of usually much faster, and can be done in a few hours. The dealership’s financing company sends the funds directly to the dealership, so the money never hits your account. You’re only responsible for handing over the down payment.
Finance & Insurance Editor
Elizabeth Rivelli is a freelance writer with more than three years of experience covering personal finance and insurance. She has extensive knowledge of various insurance lines, including car insurance and property insurance. Her byline has appeared in dozens of online finance publications, like The Balance, Investopedia, Reviews.com, Forbes, and Bankrate.