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What it Means to Finance A Car

1/29/2020

Often, financing is the best option people have when purchasing a vehicle. In many cases, certain new or used cars are not affordable without it, but it does come with a certain level of responsibility for the borrower. 

Here we’ll discuss the question, what does it mean to finance a car?

What Does It Mean To Finance A Car?

When you finance a car, you borrow money by taking out a loan to cover a significant portion of its purchase price, then make payments on that loan to your lender. Those payments are made with interest, which means you’ll ultimately end up paying back more than the vehicle is actually worth.

However, this can often be a good tradeoff since many vehicles simply aren’t affordable without some form of financing.

That said, car financing can affect your life in several ways, including those described below.

Vehicle affordability

As mentioned, an auto loan makes a vehicle more affordable by spreading out its entire price over a few years. Otherwise, you’d have to pay the full price upfront, and most people don’t have that kind of cash lying around. As such, financing allows you to keep driving without having to rely on old, worn-out models.

Higher debt-to-income ratio

Financing can have a profound effect on your financial situation by adding on to your monthly payment obligations. That means more money being paid out from your income, diminishing your ability to handle future expenses.

Every debt you take on, including auto loans, increases your debt-to-income (DTI) ratio. Your DTI ratio is used to determine whether you qualify for other forms of financing, such as a home loan. If it’s above a certain threshold, you might not qualify.

As such, if you’re planning to purchase a home in the future, it may be best to wait on auto financing.

Impact on credit

When you secure financing for a vehicle, it can impact your credit score in a number of ways. 

For instance, if your only other option would be to buy a new vehicle on your credit, financing could save you from a score decrease. This is because the more of your credit card limit you use on a card (i.e. the higher your credit utilization), the lower your credit score will likely fall.

In addition, the act of making car payments on time can further strengthen your credit score. On the other hand, if you don’t make those payments on time, your auto financing could cause your credit to take a hit.

Financial responsibility

Ultimately, a car loan is an extra financial responsibility to juggle with your other obligations. That responsibility typically lingers until the loan term is over unless you pay it off early. But it is important to note that some lenders charge additional fees for paying a loan off prematurely. 

Factors To Consider When Choosing An Auto Loan

When considering the impact a car loan can have on your life as a whole, it’s important to choose a loan that will fit your situation best. The following are a few factors you’ll need to look at when thinking about what it means to finance a car and how to make it work best for you. 

Amount you need to borrow

First off, determine how much you’ll need to borrow to get a new (or used) vehicle. Often, your financial situation may limit the amount you’ll be able to borrow, which in turn will limit how much car you can afford.

The more you borrow, the higher your monthly payments will be, and the longer it might take to pay it off.

APR

Another factor is the annual percentage rate or APR. This rate is how much interest will be charged on your loan. The lower your interest, the lower your monthly payments, and the less you’ll end up paying overall. 

Borrowers with better credit scores or who pay higher down payments will typically get lower interest rates.

Loan term

The loan term has a massive impact on your auto loan. The term is how many months your loan will last—typically between 24 and 84 months. 

A shorter loan term may result in higher monthly payments (since you’re not spreading out the amount as much), but it also means you end up paying less interest since it has less time to accrue.

On the other hand, a longer loan term equates to lower monthly payments, which won’t increase your DTI ratio as much, but will end up costing the most interest long-term.

GAP insurance

As you drive your car, it will depreciate in value. For that reason, many car loans come with GAP insurance to cover the difference between your vehicle’s current value and the amount you still owe on your car. In the event of an accident where your car is totaled, GAP insurance covers the difference.

Different lenders may charge different monthly rates for GAP insurance, so it may be worthwhile to choose one who offers the most favorable rate. Be sure to check out the GAP insurance options that OUCU offers.

Tips For Responsible Car Financing

When purchasing a car, it’s important to finance it responsibly. The following quick pointers can help you to do so:

  • Consider your current finances. How much room do you have in your budget?

  • If you’re planning on buying a home at some point, be careful to keep your DTI ratio below 43%.

  • If you have subpar credit, spend some time improving it before applying for car financing.

  • Choose a loan term as short as you can afford to minimize interest.

  • Avoid lenders that charge prepayment fees.

When choosing car financing, talk to your lender about your options. They can help you determine the best option for your situation.

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