What Does It Mean to Finance a Car?

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This is completely coincidental, but I actually purchased a used car recently, after being car-less for nearly four years. Even though the car was used, I still had to finance it.

Financing a car means you’re borrowing money from a bank or financial institution so you can purchase the car from a dealership or private party. For me, financing a car means suddenly having to commit to a huge chunk of debt and pay the bank more money in the form of interest. To be honest, the financing part sparked some major inner turmoil.

This car purchase marks the sixth car I’ve owned in my adult life, so trust me when I say financing is a huge financial commitment. You’ll need to repay this loan back for a number of years… every single month. Just that thought alone made me cringe.

The Cost of a Car Beyond Monthly Payments

If you’re thinking about financing a car and only focusing on the down payment and monthly payments, you’re missing the other added costs that come with having a car. These include:

  • Insurance
  • Gas
  • Maintenance & repairs (oil changes, car washes)
  • Unexpected costs (flat tire, parking tickets)
  • DMV registration fee

Why Finance?

Most consumers don’t necessarily have large chunks of cash laying around to purchase a new car outright, so they apply for a loan at a bank or financial institution to pay for the car. Then, based on your credit history and income, the bank will set an interest rate so that monthly payments can be made for the next 3 to 5 years, or longer.

The repayment time frame is up to you. I chose five years, but plan on paying it back as early as I can. There’s no early repayment penalty fee for my loan. (This is something you should ask about, in case you want to pay off the car early.)

If you’re making payments on a vehicle, it means the car belongs to the bank, not you. Until you pay off the loan and receive a “pink slip,” also known as the title of the car, you are technically not the true owner.

If you’re still financing a car and decide to sell it, you’ll have to make sure the balance of what you owe is covered in the cost of the car.

How Much Should You Have for Your Down Payment?

When you finance a car, you typically need a cash down payment. The higher the down payment amount, the lower the monthly payment — same concept as a when you purchase a house.

Most lenders recommend that you put down at least 10 percent or more of the vehicle’s sale price, so if the car you’re interested in costs $25,000, you should put down at least $2,500.

Keep in mind that there’s also tax and license. This may cost another few thousand dollars depending on the cost of the vehicle and the state you live in. My tax and license fees came out to about $2,500. If you don’t pay for this, you can roll it into your monthly payments. But this will raise the cost of the car.

How to Estimate Your Monthly Payments

Let’s say the car you want to purchase is $25,000. You have $2,500 for a down payment, qualify for a 3 percent interest rate, and decide to go with a 5-year loan (or 60 months). We’ll assume you were able to pay the full amount of tax and license fees.

Your monthly payments will be about $404 a month.

You can play with the numbers on a Cars.com calculator.

Dealerships sometimes offer a zero down payment option for certain cars. If you choose this route, expect that your monthly payments will be higher. If we use the same example from above and don’t put any money down, your monthly payment will be about $449.

Shopping Around and Hard Credit Pulls

When I was looking at cars, I shopped around for the best interest rates from various banks and lenders. Before this car, however, I had always stuck to the dealership’s bank of choice.

You don’t need to go with the bank that the dealership partners with. A few of the car dealers actually encouraged me to go with the bank they used even though the interest rate was higher than what I was quoted elsewhere. Their rationale was that “it’s an easier transaction” when you choose their lender.

Of course, you’ll need to get your credit pulled. But, you don’t need to worry about your credit being pulled multiple times, which may result in lowering your score. If you’re shopping around for a car, it will only appear as a hard pull once on your credit, even though multiple lenders are pulling your score.

The only thing you need to be aware of is the timeframe in which various lenders are pulling your credit. This ranges anywhere from 14 to 30 days. As long as inquiries are made within this period, it will only count as one hard pull.

This rule also applies to people who are shopping around for a home and need to get their credit pulled from multiple lenders.

Tip: If you’re shopping for a car and your credit isn’t in the best shape — if you’re subprime or have a credit score that’s in the 550-620 range, considering improving it to the high 600s or low 700s before shopping. That way, you may qualify for lower interest rates from banks. This means less money being wasted over the life of the loan.

Should You Get Pre-Approved?

Rates fluctuate frequently, so for this reason, it may make sense for you to get pre-approved from a bank. This pre-approval status locks in your interest rate and shows the dealer that you’re serious about buying.

Until you can get pre-approved, banks can only give you a quote. This is just an estimate of how much you’d qualify for.

Which Lender to Choose

When I shopped around for interest rates, I not only looked at the numbers, but I also considered the bank it came from. While this doesn’t seem all that important, it matters. You will be dealing with this company for the next handful of years.

While I don’t necessarily have a preference for a specific bank, it made sense to go to the two banks I use, before looking at other lenders. I use Chase and Ally Bank but unfortunately, their rates weren’t as competitive as Capital One Auto Finance. I ended up with a 3.4 percent rate, which was fairly competitive for a used car.

New vs. Used Vehicles and Interest Rates

The car I purchased was used, so the 3.4 percent interest rate was slightly higher than what I would’ve ended up paying if it was new.

Some dealerships have really enticing offers for new cars, such as zero percent financing for the life of the loan. This was the exact deal I chose when I purchased a new car years ago from Volkswagen.

Is Financing Your Only Option for Buying a Car?

Absolutely not. In a perfect world, I would’ve had enough cash to pay for the car without putting a big dent in my savings. I could’ve gone the cheaper route and bought a car in the $10,000 or lower range. It would have had much higher mileage. But, I didn’t because I didn’t want to deal with repairs and maintenance.

It was a trade-off. I weighed the pros and cons in order to make the most informed decision that made sense with my finances.

If you’re considering whether to finance or buy, the choice is yours. But, make sure to take all the other cost factors (insurance, maintenance) into consideration on top of your monthly car payment. Raise your credit score if it’s subprime, and shop around for the best interest rate.


4 responses to “What Does It Mean to Finance a Car?”

  1. Lisa Van Gemert says:

    How in the world is a five-year car loan anything that even remotely touches a well-kept wallet? That’s insanity. It’s a cop out to say that a car that costs 10k is going to be full of needed repairs. Oh, please. This article also leaves out a huge cost: the money you are spending each month is money that could have been invested. You must calculate the loss of that growth in any calculation of expense. I cannot believe how irresponsible this article is and the damage this attitude can do to younger people reading it and justifying going into debt to buy a depreciating asset. This is unreal and disappointing.

    • Deacon says:

      I’m sorry you feel that way. If you read the article fully you will see that the author is not necessarily condoning getting a car with a loan. However, if one must get a loan, this is information on what to expect.

  2. The girl next door says:

    I have a quick question. I have my drivers license, but no insurance. I work a full time job, but have no credit at all. I have a down payment of $2,000. What are my chances of buying a car? I need help. I’m not sure what to do next.

    • Deacon says:

      Well, for starters, you can use the tips in this post. In addition, you should make sure having a car will fit into your budget. As the post states, you’re not just paying for the car, you also have upkeep, gas, etc. But if you are going to finance part of the cost and make payments, you need to have a budget and make sure the payment is affordable for you. We have a a couple posts about budgeting on this site that might help. Check them out and good luck!

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