Whether you're a first-time buyer or a seasoned shopper, purchasing a car is an exciting milestone. However, financing a vehicle can be a bit confusing. If you’re looking to finance your next vehicle, we’ll show you how to get a car loan smartly so you can hit the road with a smile.
Create a Budget
The first step to getting a car loan is creating a budget to get an idea of how much car you can afford. How much to budget for a vehicle depends on several factors, including your income, recurring expenses, and goals. However, a general rule is to budget no more than 15% of your gross monthly income — your earnings before taxes — for a car payment.
Once you figure out how much you can afford for a car, research vehicles that fit your budget. Look into each vehicle's fuel type, transmission, and safety features. These factors help estimate how much you might spend on monthly expenses, such as gas, maintenance, and car insurance payments.
Check Your Credit Score
Your credit score is a three-digit number — between 300 and 850 — representing how likely you are to pay back a loan based on your credit history. Your income and credit score will help determine how much money you can borrow and your interest rate.
You can check your credit report for free every 12 months from each major reporting bureau at AnnualCreditRepot.com. Before applying for a loan, check for any errors or incorrect information — e.g., fraudulent activity — and fix them. Ultimately, your lender could turn you down or subject you to higher interest rates if there are errors or shortcomings on your credit report.
What Is a Good Credit Score to Buy a Car?
Generally, the higher your credit score, the better your chances of financing a car with a lower interest rate. According to NerdWallet, a credit score of 661 or higher can get you a car loan with a solid interest rate. You can still obtain a car loan with a credit score lower than 661 but expect to pay a higher interest rate. If possible, consider taking six months to a year to improve your credit score before applying for a car loan.
Buying a Car with No Credit
You can finance a car if you have no credit history, but your options might be limited compared to buyers with good credit history. Lenders may be willing to work with you, but you’ll likely need someone to co-sign your lease, show proof of consistent income, and make a down payment. Shop around for lenders that work with all credit profiles and see if they can help you with your situation.
Shopping Car Loans: Prequalification vs. Preapproval
As you’re shopping for a car loan, you may come across terms like “prequalification” and “preapproval,” which are two different methods for giving insight into your auto financing options. However, it’s important to know that they don’t guarantee financing. Let’s take a look at the differences between prequalification and preapproval.
Car Loan Prequalification
A prequalification is an informal estimation of what car loans you may qualify for. Lenders base this estimation on the information you’re required to provide, such as your estimated income, assets, and liabilities. While a prequalification is quick, easy, and doesn’t affect your credit score, it’s usually less accurate than a preapproval.
Car Loan Preapproval
A preapproval is a more formal version of prequalification. With a preapproval, you have to spend a little more time gathering and submitting accurate, verifiable information to a lender, such as your Social Security number, tax returns, bank statements, proof of insurance, and photo ID. The lender will also likely make a hard credit inquiry, which may temporarily lower your credit score. However, you’ll usually receive a specific loan amount and purchase price, making it more accurate than a prequalification.
The Importance of Down Payments
When you apply for a car loan, you’ll likely need to make a down payment, which is the amount of money you put toward the purchase price of a car. For example, if you’re interested in buying a car for $20,000, a 10% down payment would be $2,000. Let’s explore how down payments work.
How Do Down Payments Work?
With a down payment, you can control how much money you want to pay upfront. Typically, the more you put down, the less you’ll need to borrow, which means a lower monthly payment and interest rate. Generally, you should try to make a down payment of at least 20% for a new vehicle and at least 10% for a used car. If these percentages are too much, put as much money down as you can without draining your savings or emergency funds.
A down payment could also help you get approved for a loan if you have an average credit history. From a credit perspective, putting down a decent down payment is seen as protection for your lender, so strive to put down as much as you can if you’re in this situation.
Financing a Car
When financing a car, you have many lending options and loan term lengths to consider.
Where Can You Get a Car Loan?
Just like there are different dealerships to shop for a vehicle, there are various types of lenders who can give you a car loan. Here are some lending options you should consider to get the best deal possible:
- National banks — Large national banks, such as Chase, Wells Fargo, and Bank of America, offer several physical locations, apps, and online portals to help you secure a loan.
- Online-only banks — Online-only banks are just like national banks but without physical branches. Examples of these banks include Ally Bank, SoFi, and Barclays.
- Captive finance companies — Captive finance companies are in-house financing entities owned by automakers. They provide traditional car loans and special financing deals for a specific auto manufacturer at car dealerships. For example, GM Financial is the captive finance company for General Motors.
- Credit unions — A credit union is a nonprofit financial institution owned and controlled by the people who use its services. You must become a member to get a loan from a credit union, usually by making a deposit. Find what credit union you’re eligible for at MyCreditUnion.gov.
Choose the Shortest Term You Can Afford
A term is the number of months you have to repay your loan. A typical loan term is between 36 and 72 months, but some terms can exceed 72 months. While a longer term may seem appealing because of the lower monthly payments, it’s not ideal. Generally, the longer your term, the more interest you’ll pay for your car. You’ll also build equity more slowly with a longer term, which may increase your chances of negativity equity — owing more than what the car is worth.
With this in mind, keep your term as short as you can afford. It's tempting to extend your term length to five or six years for a low monthly payment, but you'll pay much more in interest and potentially develop negative equity.
How Does APR Work on a Car Loan?
The annual percentage rate (APR) is the yearly cost of a car loan, shown as a percentage that includes your interest rate and other fees associated with your loan. An APR can be a great way to examine the affordability of different loans when you’re shopping for one.
There are a few factors that can affect your APR. If you have good credit, you typically have a better chance of locking in a low APR. On the other hand, if you have a low credit score, you’ll likely have to pay more in interest and other fees, which means a higher APR. You may also get a better APR if you choose a lower-mileage car or a new one.
Whether you’re looking to finance a new or used vehicle, getting a car loan can be a great way to buy a vehicle while building your credit. Explore your options, shop for the best deal, get familiar with all the terms and conditions, and pay your monthly payments on time. If you’re also considering leasing a vehicle, check out our financed vs. leased blog to help you make the best decision.
Regardless of your path, don't forget to insure your new vehicle with Mercury Insurance, where we provide best-in-class coverage at an affordable rate.
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Car Finance Terms
Here are several common car finance terms you need to know:
- The amount of cash you put down toward the purchase of a car.
- The number of months you must pay back your car loan, usually between 36 and 72 months.
- The monthly amount you must pay to your lender to repay your car loan.
Annual Percentage Rate (APR)
- The yearly cost of a car loan represented as a percentage that includes your interest rate and other loan-related fees.
- The amount you pay for borrowing money for a car loan — a percentage of the total loan amount.
- An informal estimation of your car loan eligibility, which doesn’t affect your credit score.
- A formal estimation for your car loan eligibility where you must provide verifiable information. It also affects your credit score.
- A person who assumes equal responsibility for your car loan. You usually need a cosigner if you have poor credit or no credit history.