What is car financing and how does it work? (Guide 2023)

2. Set a budget

Before financing a car, determine how much money you can afford monthly and in total to pay off a car loan. It’s easy to forget the purchase price of your dream vehicle while shopping for a car, but be realistic about your budget.

Your Annual Percentage Rate (APR), the interest rate on your car loan plus any fees, determines how much you pay to finance your car. Your APR depends on factors such as your creditworthiness, the length of your loan, and the amount you borrow. While new vehicles typically cost more than used vehicles, they typically have lower APRs.

3. Gather the required paperwork

There are four main requirements when financing a car:

Proof of Identity: You will need to verify your identity with government-issued identification, which may include your passport, driver’s license, and birth certificate. Proof of Income: To ensure you can make payments on time, documents such as recent payslips, recent bank statements, a recent W-2 form, or other declaration. If you are self-employed, the last two years of your tax return can also be used for proof of income. Proof of Insurance: As with any auto loan or vehicle financing, you will need proof of minimum insurance required by your state. Getting this is usually easy, and you can call your auto insurance company for a folder showing you have the right coverage. Proof of Residence: Proof of residence may include your driver’s license, utility bills, insurance bills, mortgage or lease statements, and bank or credit card statements.

In some situations, you may need additional information to finance a car, such as your social security number or vehicle purchase documents. If you are financing a used vehicle, you will need the original title document before proceeding with an auto loan.

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4. Get rates from auto lenders

Lenders may not offer the same APR and loan terms when you finance a car. Therefore, compare the tariffs of car loan providers. There are many options for vehicle financing, from dealerships and banks to companies that specialize in car loans.

When seeking quotes from auto loan providers, you need to understand the differences between prequalification and preapproval when financing a car. Pre-qualification provides an estimate of your interest rate, but since potential lenders only perform a gentle credit check, the interest rate may change after you apply for a loan. Pre-approval comes after a rigorous credit check and almost guarantees financing on the terms set out in the pre-approval offer.

Pre-approval may result in a slight deterioration in your credit score, but allows a serious buyer to calculate monthly car payments for the life of the loan. FICO counts all credit checks related to your auto loan as a single request for up to 45 days, so installment shopping doesn’t affect your credit score more than once.

5. Choose the best car lender for you

Everyone has different needs when it comes to financing a car. While some avoid auto lenders with higher interest rates, others would be happy with any provider willing to finance their vehicle.

When choosing a car lender, consider the following factors:

APR: The lower the APR listed in your contract’s disclosures, the less you pay to borrow money. Term: Your loan term can vary greatly. A long-term loan usually means you pay less per month but more over the life of the loan. Down payment: A substantial down payment can save you interest when financing a car. The minimum down payment — if any — is set by each auto lender. You may be able to use the trade-in value of your old vehicle to pay a deposit for a new vehicle.

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