How Car Financing Works

Sources of Financing

There are several different ways that you can finance your car, and there are pros and cons about each of them.
  • Pros: Convenient, fast, sometimes competitive
  • Cons: High pressure, usually not competitive; be prepared for a big sales push on add-ons; loans are often front-loaded (payments are made up of more interest in the beginning of the loan than toward the end -- that's bad if you think you may be paying the loan off early.)
Bank or credit union
  • Pros: Competitive rates, personal service, no sales pitch for add-ons; often can tell you if you're paying too much for a car; often provide free life insurance or disability insurance with loans; loans are usually simple interest loans (interest spread evenly throughout the term of the loan)
  • Cons: Not as convenient as dealership financing -- can't set it up at night or on the weekend
Online financial institution
  • Pros: Usually competitive rates, quick, easy
  • Cons: Not a personal service; dealing with an unknown; some scams to watch out for
Home equity loan:
  • Pros: You can deduct some of the interest from your taxes; competitive rates
  • Cons: You're tying your car to your home (may be risky)

Family member or friend

  • Pros: Personal service, easy, sometimes flexible; usually competitive rates
  • Cons: Could jeopardize a relationship

Determining the Rate
The interest rate you get when financing a new or used car can vary quite a bit from the advertised rates you see on TV or read in the paper. Probably the biggest influence on your rate is your credit rating (see How Credit Scores Work to get the full story). Your credit history and credit score tell lenders a lot about your money habits and are designed to give them an idea of what their risk is if they loan you money. They often raise the interest rate if your loan is seen as high-risk.

Another thing that affects the rate you get is the length (term) of the loan. Typically, the shorter the loan, the lower the rate. Keep in mind that the shorter the term, the higher your payments will be.

Used cars will have higher rates than new cars. The newer the car, the lower the rate. (You may find an exception to this rule at some credit unions. Some give the same interest rate for new and used cars.)

Your geographic location can also be a factor in the rate you get. Your cousin may have gotten 7 percent on the other side of the country, but in your home town, 8.5 percent may be the lowest rate you can find.

While these are the usual things that affect the rate you get through a bank or other financial institution, financing through the dealership may or may not actually work this way. Find out why in the next section.