How Does Financing a Car Work?

Car loans are available even to those with prior bankruptcies.
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Auto financing typically is done through either the car manufacturer or a more traditional lender such as a local bank or credit union. Car loans are provided based on your credit score, income, assets and debts and are subject to all types of adjustment based on your desirability as a borrower. Financing a car is often a complex process that does not need to be.

Dealer Perspective

Some buyers believe dealers prefer a customer who walks in with cash and makes the deal. In reality, dealers stand to make much more off the interest and fees involved with a financed vehicle than a simple cash sale. Financing is a major part of the income of any auto dealer. From the point of view of the buyer, a car loan works like the key that gets you into a vehicle you may not otherwise be able to afford. It is important to do some shopping both for the loan and the car, then get your best price at the dealer before broaching the subject of financing. Car loans can be beneficial to both parties if you understand how they work and what to avoid.

Getting Approved

The interest rate on car loans can vary tremendously based on the financial profile of the person making the purchase. If your credit score is excellent and you make enough income to cover your debts easily, you should be able to secure the lowest rate offered. If there are any issues with your profile, the rates will be adjusted upward to compensate the lender for the increased risk involved with making the loan. If you have less-than-desirable credit, the lender may request more of a a down payment to raise your stake in the purchase and to reduce the overall principal being borrowed.


Once you have been approved for the auto loan, the type of interest due also can make a significant difference in the monthly and overall cost of the car. If your loan is a simple-interest loan, it will be calculated on the total balance alone. For example, if you buy a car for $10,000 at 5 percent interest, the interest on the principal will be $500. In the case of a loan with compound interest, the interest for a given period of payments (a year, for example) will be added to the principal and the interest will be assessed on the overall total. Simple-interest loans are more desirable for the borrower but are harder to come by in the auto market.


Although the incentives that car dealers offer can be tempting, in the end they may cost you more. Car dealers often offer on-site financing at a rate that sounds competitive with traditional lenders. What you don't see are the built-in fees, dealer commissions, points and compound interest, which bring the overall cost of the car well above what it would be with a bank loan at standard market rates. Even if you elect to use an outside lender but allow the dealer to shop around for you, kickbacks and commissions paid to the dealer by the lender will increase the cost of your loan. Always check out the dealer incentives being offered, but read the fine print and shop around for your loan.

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