How Does Auto Financing Work?

Auto financing is an area in which a great car deal can suddenly turn sour. Many car buyers spend an enormous amount of time and effort getting a dealer to agree to a low purchase price and a decent trade-in value, and then they throw all that hard work away by failing to be nearly as diligent in obtaining their car loan. Their lack of preparation on the equation's financing side means they potentially throw away hundreds, or even thousands, of dollars. 

Woman Shopping Online for Car Loan

To get the best deal, it is critical to understand the answer to the question: how does auto financing work? Happily, free online sources are available to help you get the best deal without ever leaving your home.

With a traditional vehicle purchase, there are typically three separate transactions:

  • The car-buyer is purchasing a vehicle
  • The dealer is purchasing a vehicle (the car you're trading in)
  • The car buyer is purchasing financing 

That last transaction is the subject of this article. With auto financing, a lot of money is at stake. Yet, many consumers treat it as an afterthought or don't even think about it at all. That's a shame because you can save hundreds and perhaps thousands of dollars by using online resources and techniques to get the best deal on a car loan.

Understanding Auto Financing is Essential - Find the best car deals!

If you think of your car loan as something that you purchase just like you are buying anything else, it should put the importance of understanding auto financing in perspective. In the case of a car loan, you are purchasing the use of money now that you will re-pay over time. Very few people can afford to buy a new vehicle with cash. So the auto industry makes it very easy for them to borrow money. In fact, the entire auto industry runs on credit.

Let's say you're going to buy a $35,000 car, and your current vehicle is paid for and worth $15,000. If you trade it in, you need to come up with $20,000 to complete the purchase. If you don't have the cash, borrowing the money is the answer. If you have a decent credit history, many companies will eagerly lend you that $20K. But it takes some effort to get the best loan terms available.

Some sources of auto financing are less expensive than others. Your job as an online car loan shopper is to find the one that is the least expensive for you. And it is useful to do that before you enter into any kind of online buying process, including with apps like Carvana, Shift, and Vroom. Since dollars are dollars, you don't have to worry about the quality of the product you are buying. You simply need to compare the price of that product — in other words, the terms of the loan. 

The transaction is so straightforward it is ideal for online shopping. By doing a simple Internet search for "car loans," you will discover hundreds of purveyors of auto financing. Many vehicle lending sites facilitate comparison shopping. In seconds after you search online, you'll be able to see the car loan rates for new and used cars across a wide selection of potential lenders.

Know Your Credit Rating - Find the best car deals!

Shopping for a car loan online is simple, and it would be even simpler except for one big thing: When you are borrowing money, some people must pay more for that privilege than others do. 

While this might seem unfair, there are time-tested reasons why this is the case. Some people must pay more for borrowing money than others because they are less likely to pay it back. 

This is what your credit rating tells potential borrowers. It takes your credit history — the money you've borrowed in the past and how successfully you've paid it back on time — and gives you a numerical score that informs lenders how risky it is to lend money to you. 

If you've demonstrated a record of borrowing money and paying it back on time, you will have a high credit score. A high credit score means you will pay less to borrow money because the lender's risk is low.

If you've been late on payments or failed to pay some loans back at all, you will have a low credit score. A low credit score means you will pay more to borrow money because the lender's risk is higher.

Knowing this is essential to understanding how auto financing works.

Before you set out to buy a car, make sure your credit score accurately reflects your actual credit history. If there are errors on your credit report that reflect poorly on you — for example, the report shows you still owe money that you, in reality, have paid back — it will hurt your credit rating and, in turn, make it more expensive for you to get a car loan. 

You can get a no-cost look at your credit score and your credit report from any of the three primary credit reporting services — Equifax, Experian, and TransUnion. The law requires each of those companies to provide free access to your credit score and view your credit report.

A few weeks before applying for a car loan, you should visit each of these companies online and take advantage of this free opportunity to examine your credit history and learn your credit rating. If there are discrepancies, take immediate action to correct them before applying for auto financing.

How to Shop Online for a Car Loan - Find the best car deals!

Once you are confident that your credit report and credit score accurately represent your creditworthiness, then you are ready to shop for a car loan online. 

The internet offers quick access to numerous potential car-loan sources, and some lenders will charge you more than others because their business requirements and policies differ. But don't worry. You can find a reputable auto financing source online and with a favorable interest rate for the loan.

The following are descriptions of recommended auto loan sources with commentary on each:

  • Banks. Most of us have at least some relationship with a bank via our personal checking and savings accounts. Some of us also have a home mortgage with a bank. In many places, the local bank is the heart of the business community. Your bank could be a good source of a car loan.
  • Credit Unions. Credit unions function much like banks. Millions of Americans use credit unions for savings, checking, and loans. Credit unions are mutual organizations owned by their member-depositors, so they might offer better rates than other institutions.
  • Finance Companies. Some auto finance companies are associated with national or regional banks. Others are related to individual automakers. For example, those in the latter category, like Toyota Financial Services, are referred to in the industry as captive finance companies because of their affiliation with a single manufacturer. However, like other finance companies, they typically write loans on all brands of vehicles, both new and used.

Each type of financial institution above requires a degree of creditworthiness to get a loan. If you have no credit or a low credit score, you might still be able to get a car loan, but you will need a co-signer, someone who promises to make the payments if you don't.

Critical Advice: Get Pre-approved for a Loan Before Finding a Car - Find the best car deals!

As you shop for a car loan, you will compare offers between different lenders. Using the same loan amount, down payment amount, and term of the loan in months or years, you can compare the different rates available to you on an apples-to-apples basis.

Ultimately, your goal is to get pre-approved for a loan using a lender's online process. Pre-approval means that the lender will give you a loan for a specified amount, term, and interest rate when deciding on the actual vehicle you will purchase. 

Once you are pre-approved for a car loan, one of the three parts of the purchase is complete before you start shopping. You know how much you can afford, what your monthly payment will be, and your interest rate, or the amount you'll pay for the privilege of borrowing the money.

Having a pre-approved loan in place is a golden ticket that enables you to shop for a car as if you have cash in your pocket. It gives you leverage when negotiating price and when comparing an auto loan a dealer offers you to the loan you already secured online. You also protect yourself from unscrupulous dealers who might sell you a high-interest-rate loan with an extended payment term but which has lower monthly payments.

You do not want to be what is known as a payment buyer when you're finalizing a vehicle purchase with a dealer. Dealers can easily arrange financing that meets your monthly payment requirements, but which is not a good deal otherwise.

Also, keep in mind that when you apply for a car loan, the lender needs to know whether the vehicle you're buying is new or used. This is because the vehicle is the collateral for the loan. If you default on the loan by not making your payments, the lender can take possession of the car (repossess it) to offset the loss it experiences by your failure to make the loan payments.

Often the interest rate you will pay for a used car purchase will be higher than the interest rate for a new car purchase, even if you are asking for the same amount of money. Why? Experience has proven that used car loans are riskier than new car loans. Your credit rating is the same in both cases, but the car's status, new or used, makes the difference.

Getting Auto Financing From a Dealer or Car Company - Find the best car deals!

Loan pre-approval means you are well on your way to finalizing your loan and purchasing your next car, but it is not the last step in the journey. 

At this point, another critical loan-shopping step is researching incentive financing online. Car companies frequently promote their vehicles' sales by offering special financing deals in conjunction with their dealers. Through their captive financing institutions, automakers can offer special incentives that could save you thousands of dollars over the course of your loan. 

Take the frequently promoted 0% financing deals, for example. Obviously, no outside lender will lend you thousands of dollars without charging you interest payments. To offer you no-interest financing, the car company, the dealer, and the captive finance institution subsidize the loan to persuade you to buy the car. 

These offers will get your attention, but they are generally available only to consumers with outstanding credit scores. You might not qualify, or you might be eligible for a better-than-market interest rate but not the best 0% rate. To find special financing deals — and other offers — associated with the model you want to buy in your area, go to the automaker's website.

Summary - Find the best car deals!

Now that you know how auto financing works, you are ready to go shopping. When you are pre-approved for a loan, you know what you can afford, what your monthly payment will be, and the interest rate you'll pay for the loan. You also know if you're likely to qualify for special manufacturer-dealer financing, which could save you even more money.

Your loan pre-approval gives you leverage. Let the dealer know you are pre-approved for an auto loan and the terms of that potential loan. Sometimes the dealer will be able to offer you a better car loan than you had found for yourself. 

If you like the better deal, you can likely complete the entire financing and purchase process online and arrange for vehicle delivery to your home or place of business. But if you don't like the alternative deal, purchase the vehicle using your pre-arranged online loan. 

Either way, you can feel good that you have done your financial due diligence as you shopped for a car loan online.

Jack R. Nerad has covered car buying, auto retailing, and the automotive industry for more than three decades. He has held editorial director posts at dealership, consumer, enthusiast, and market research publications; appeared on television as a car-buying expert; and hosts a popular podcast. He is the author of several books, including The Complete Idiot's Guide to Buying or Leasing a Car.