How to Finance a Car the Smart Way

By Justin Yoshizawa and the Mercury Team

Buying a car is exciting. Financing it? That part can get confusing fast: APR, loan terms, down payments, and a stack of paperwork. But once you understand the basics, you can shop smarter, avoid common traps, and choose a loan that fits your budget. This guide breaks down how to finance a car, how auto loans work, and the steps to take before you sign anything.

What Does It Mean to Finance a Car?

It means you’re borrowing money to buy the vehicle, then paying that money back over time (typically monthly installments with interest). Most people finance through an auto loan from a bank, credit union, online lender, or the dealership’s financing partner.

There are three main components you need to understand:

Principal: This is the total amount of money you’re borrowing.
Interest Rate: This is the cost of borrowing that money, usually expressed as an Annual Percentage Rate (APR).
Loan Term: This is the length of time you have to pay back the loan (typically between 36 and 72 months).

It’s important to note that financing differs from leasing. When you finance, you’re paying to eventually own the car. When you lease a car, you’re essentially renting it for a few years with limitations on mileage and customization.

How Auto Loans Work

When you finance a car, you’re basically teaming up with a lender. The lender pays the dealership (or seller) for the car upfront, and then you repay the lender over time in monthly payments.

Here’s what’s happening behind the scenes:

Who the lender is: It could be a bank, credit union, online lender, or dealership financing. They review your info to decide your approval and rate.
How your credit score fits in: Your credit score is a big factor in your APR. In general, stronger credit can mean a lower rate, but it’s still worth comparing offers either way.
What a down payment does: This is money you put down to reduce how much you borrow, which can lower your payment and total interest.
How interest shows up in your payments: With most auto loans, interest is calculated based on the balance you still owe. Early on, more of your monthly payment usually goes toward interest. As you pay down the loan balance, more of your payment starts going toward the car itself.
What you’ll usually need to apply: Proof of income, proof of residence, ID, insurance info, and details about the vehicle.

How to Finance a Car: Step-by-Step Guide

How do you finance a car without overpaying? Use these steps as your checklist.

Step 1: Set a Realistic Budget

Before you look at cars, look at your bank account. A general rule of thumb is that your car payment should not exceed 10% to 15% of your take-home pay.

However, the monthly loan payment isn’t your only expense. You must also factor in the total cost of ownership, which includes fuel, maintenance, and car insurance. If you stretch your budget too thin on the car payment alone, you might struggle when it’s time for new tires or an oil change.

For a detailed checklist on what to bring to the dealership, check out our guide on what you need to buy a car.

Step 2: Check Your Credit Score

Knowing your credit score before applying for a loan gives you leverage. Lenders rely heavily on this number to determine your interest rate. If your score is high (generally above 661), you have a better chance of securing a low rate.

If your score is lower than you’d like, consider delaying your purchase for a few months to pay down existing debt or correct errors on your credit report. Even a few points can make a difference in what you pay each month.

Step 3: Save For a Down Payment

While it’s possible to buy a car with little to no money down, it’s rarely the best financial move. A substantial down payment (ideally 20% for new cars and 10% for used cars) offers several benefits:

It lowers your monthly payment.
It reduces the total amount of interest you pay over the life of the loan.
It protects you from being upside down on your loan (owing more than the car is worth) as soon as you drive off the lot.

Step 4: Compare Auto Loan Options

Don’t automatically accept the financing offered by the dealership. While convenient, dealer financing can sometimes come with higher interest rates (typically called a “markup”).

Banks and Credit Unions: These institutions often offer competitive rates to their members.
Get Preapproved: Getting preapproved for a loan gives you a “blank check” to take to the dealership. It locks in an interest rate and budget, preventing you from being upsold on a more expensive vehicle.
Red Flags: Be wary of lenders who focus solely on the monthly payment rather than the total cost of the car. This is a common tactic to hide a high interest rate or an overly long loan term.

Step 5: Choose a Smart Loan Term

The length of your loan has a big impact on your finances.

Short Terms (36-48 months): You will have higher monthly payments, but you will pay much less in interest and own the car sooner.
Long Terms (60-84 months): These lower your monthly payment, making expensive cars seem affordable. However, you will pay significantly more in interest, and you risk owing more than the car is worth for a longer period.

Ultimately, pick the shortest term you can comfortably afford without stretching your budget too thin.

Step 6: Understand the Full Cost of Ownership

Two cars with the same price can cost very different amounts to own.

Costs that often change by make/model include:

Insurance premiums
Repair costs
Fuel needs (regular vs. premium)
Tires, brakes, and routine maintenance

If you’re deciding between buying a new or used car, depreciation and warranty coverage can matter, too.

Step 7: Review the Loan Agreement Carefully

Before you sign, read the fine print. Look for hidden fees, such as prepayment penalties (a fee for paying off the loan early) or unnecessary add-ons like extended warranties or gap insurance that might be cheaper to buy elsewhere.

This is your money and your contract. If you don’t understand a fee, ask about it. You have the right to decline optional add-ons.

Factor in Your Insurance Before Finalizing the Purchase

Many buyers forget to check insurance rates until after they’ve bought the car. This can lead to a nasty surprise if the premium is higher than expected. Insurance costs are based on the car’s value, safety ratings, and repair costs.

Before you sign the final paperwork, call your local agent or get a quote online. If you’re purchasing a brand-new vehicle, check out our guide on buying insurance for a new car to make sure you have the right coverage from day one.

The Smartest Move After Financing a Car: Protect Your Investment

Once you have secured the right financing and the keys are in your hand, the final step is protecting your investment. Your car is likely one of your most valuable assets, and having the right insurance coverage gives you peace of mind on the road.

“Financing is only part of the cost of owning a car. Getting an insurance quote before you buy helps you see the full monthly picture and choose coverage that protects what you’ve worked hard to afford,” says Justin Yoshizawa, Director, State Product Management for Mercury Insurance.

At Mercury Insurance, we believe in helping you get the most out of your budget. Our local agents can help you find discounts and tailor a policy that fits your specific needs, so you have great coverage at a great price.

Common Questions About Financing a Car

Take a look at some frequently asked questions about financing a car.

Do you need credit to buy a car?

It’s possible to buy a car without a credit history, but you may have fewer options or higher APR offers. Some buyers choose to apply with a co-signer, increase the down payment, or look for lenders that work with first-time borrowers.

Should you finance through a dealership?

Dealership financing can be convenient, and sometimes promotional rates are available for qualified buyers. But it’s still smart to compare it with preapproved offers from banks, credit unions, or online lenders.

How long should a car loan be?

The right term depends on your budget and goals. Shorter terms often cost less in interest overall, while longer terms can increase total cost. Compare offers based on total loan cost — not just the monthly payment.

Is it better to buy new or used?

Used cars can cost less upfront and may lose value more slowly than new ones. New cars may come with newer safety features, warranties, and sometimes better financing offers. The best choice depends on your budget and what matters most to you.

Justin Yoshizawa

Director of Product Management at Mercury Insurance

Justin Yoshizawa is Director of Product Management for Mercury Insurance, overseeing California’s personal lines, including auto, homeowners, landlord, and umbrella. He has led major initiatives such as the rollout of the aligned umbrella product across all Mercury territories and serves as a company spokesperson on auto-related topics. Yoshizawa holds dual Bachelor of Science degrees in Applied Mathematics and Applied Statistics from UC Santa Barbara.