How to Finance a Car and Get a Car Loan

With a credit crunch squeezing everyone from General Motors down to individual car buyers, now may not seem like the best time to buy a new car. But there are still good deals to be had. The problem most people have is getting the financing to take advantage of those low prices and current incentives.

Car financing is tricky even when the credit market is good. Now that the credit market is tight, it's back to basics for buyers and lenders. Check out the car financing basics covered below to make sure you get the best car loan for your next vehicle.

The Basics of Car Loans

Getting a car loan simply means borrowing money to pay for it. Borrowing money probably isn't new to you -- everyone's bummed $10 from friends. When you borrow from a lender, the amount you borrow is called the loan principle. Though the basic idea behind borrowing money for a car is the same, when it comes time to pay the loan back, things get a little complicated.

Unless your friends don't like you much, they're not going to charge you interest on money you borrow. But professional lenders will. A bank isn't your friend and doesn't lend money out of the goodness of its heart. It needs a financial incentive. That's what interest provides for the lender: a financial incentive to lend money.

When you take out a loan for a car, it'll come with an interest rate -- a certain percentage of a loan that you must pay back in addition to the original loan amount. So, if you borrow $20,000 for a car at a 5 percent interest rate, you're going to end up paying the bank $21,000 over the life of the loan -- that's the principle, plus the interest.

The Car Loan Term

The life of the loan, or loan term, simply refers to the amount of time you have to pay the lender back. If you sign up for a five-year term, in five years you'll pay the money back and will own the car free and clear. What the loan term doesn't mean is that five years from now you'll have to come up with all of the money. The vast majority of auto loans are repaid in monthly installments. You send the lender a set amount each month and slowly pay off the loan.

Most people think that when you finance a car, the finance company lends you the money and the car is yours. That's a simple way of looking at it. In reality, however, the lender is buying the car and letting you use it. The lender technically owns the car, though you agree to be responsible for it. In fact, you won't have the title to the car until you make your last loan payment. Miss loan payments and the lender repossess the car. Each payment you make buys you a little more of the car, but you don't fully own it until the loan is paid off.

Now that you know the basics, you're probably wondering how people can screw up financing a car. Believe it or not, there are plenty of ways.

Your Credit Score

All interest rates are not created equal. Some people get charged more interest, and some get charged less. Obviously, you want to get charged less. The interest rate lenders charge is based largely on your credit score -- a number that's assigned to you based on how much other debt you have and how good you've been about paying bills on time. Lenders use the score to assess how likely you are to pay them back. If your score is low, they'll think you're not likely to repay the auto loan and charge you more money to cover that risk.

Young people often have lower credit scores than older people, even if they've been good about staying out of debt and paying their bills. That's because young people don't have long credit histories, which makes it difficult for lenders to tell how much of a risk they are. As a result, people without long credit histories can be charged higher interest rates too.

You should know what your credit score is and do your best to make sure it's high. For a small fee, you can get it through Equifax, Experian or TransUnion. If your score is not as high as you'd like, paying off old bills (like credit card debt) and paying all bills on time (the full balance, not just the minimum due) for six to nine months should bring your score up and interest rate down.

Apply, Apply, Apply

You didn't apply to just one school, so you shouldn't apply to just one lender for a car loan. Contact your bank, local credit unions and other lenders to find out what they're offering. You'll have to fill out loan applications, which will ask for your employment history, income, expenses and debts. Do not be tempted to exaggerate your income or misstate your expenses. Everything you fill out on a loan application will be verified and lying will get you into serious trouble. The lender will pull your credit history and credit score and make you a loan offer based on that information.

Take some time to go over all the offers. Don't just look at the interest rates -- avoid offers that charge you a lot of fees. Also, watch out for loans that have a prepayment penalty; that's a charge that you'll owe if you pay the loan off early. Paying the loan off early may not be something you'll be able to do, but if your long-lost Aunt Maybel dies and leaves you a fortune, paying it off could save you a lot of money -- and you don't want to pay extra to do it.

Don't be Dejected about Getting Rejected

Don't feel too badly if your loan application is rejected. It's probably a good thing. A rejected loan application means the lender didn't think you'd be able to pay the money back. As hard as that is, that lender just saved you from getting into debt over your head. Try finding a less expensive car to buy, or saving up more money.

Show Up with Financing

Most car buyers assume that the car dealership always has the best financing deals. That's not always the case. While you should certainly consider the loan the dealership offers, it's a good idea to have an approved loan application from a bank or credit union when you go to the dealership. That way, you'll know if the dealer is offering you a good financing deal, and you'll have an alternative if they're not.

Having financing all ready also means you'll be protected from some dealer tricks. Some dealers will give you a great price on a car, but will charge you a higher interest rate on the loan, which will cost you more money in the long run. With financing in hand, you can focus on the price of the car.