How do car loans work?

Woman sits in her new car as the deal hands her the keysImage: Woman sits in her new car as the deal hands her the keys

In a Nutshell

Car loans can be confusing and overwhelming — especially if it’s your first time financing a car. From interest rates to down payments to the length of your loan, there’s a lot you  need to understand. But the better you understand auto financing, the more prepared you’ll be to negotiate the best deal for your situation.

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Buying a new or used car may be one of the biggest purchases you make in your lifetime. With all the moving parts that come with a car loan, figuring out how to pay for your ride can send you for a spin.

With the average price of a new car hovering around $35,000, according to a Consumer Financial Protection Bureau blog post published in 2018, chances are you’ll have to take out a car loan.

But before you pick out your next set of wheels, it’s a good idea to do a little homework on auto financing first. In this article, we’ll take a closer look at the most common types of car loans, auto loan lenders, important key terms to know and how to prepare to apply.


What is a car loan?

When you don’t have the cash on hand to pay for a new car, a car loan can help you buy it — whether the vehicle is new or used. When you get an auto loan, you borrow money from a lender to buy a car. You agree to pay back the funds over a set period of time, plus any fees and interest you accrue.

Key terms to know

Before we get into detail about how car loans work, let’s take a moment to get familiar with some of the most common terms you may come across as you explore loan options.

  • Annual percentage rate — APR is the amount you’ll pay to borrow the money, including interest and fees, given as a yearly percentage. The higher the APR, the more you’ll owe in return for the loan.
  • Down payment — This is a payment you make upfront toward the cost of the car. It can be cash, the value of a vehicle trade-in or both. The down payment helps lower the overall amount you need to finance — which can mean lower monthly payments.
  • Loan term — Also called loan duration, this is the length of time you’ll have to pay off your loan. Keep in mind that the longer your loan term, the more you’re likely to pay in interest.
  • Monthly payment — The monthly payment is the amount you owe each month. It’s made up of principal, interest and other fees, if applicable.
  • Principal — This is the amount that you are borrowing minus fees, penalties, interest and other costs.
  • Total cost — Total cost refers to the total loan amount, or overall principal and interest, you’ll pay over the life of your car loan.

How do car loans work?

A car loan is paid back to the lender in monthly installments called loan payments. Your monthly payment will depend on the amount of the loan, the loan term and the amount of interest you’ll have to pay over the course of the loan.

Your loan contract is broken down into the principal and interest on the loan, along with any optional add-ins.

Longer-term loans, like 60-month or 72-month loans, can make your monthly payment lower. But keep in mind that with a longer loan term, you could end up paying more over the life of the loan when you add up the interest. You may even end up owing more than the car is worth, causing you to be upside down on your loan.

Let’s compare a $20,000 loan at a 3.75% interest rate across two different loan terms. Keep in mind this calculation does not include any applicable sales tax.

Loan term Monthly payment Total interest paid

3 years (36 months)

$588

$1,177

5 years (60 months)

$366

$1,965

Though the longer loan term lowers your monthly out-of-pocket costs, if you opt to pay the loan back in five years instead of three years, you’ll end up paying an additional $788 in interest over the life of the loan.

3 factors affecting your car loan payment

Most common types of loans

You can use a car loan to purchase a new or used vehicle. You can also apply for a loan to buy out a lease or refinance an existing loan. You may find that new-vehicle loans have lower rates than used-car loans and sometimes come with special incentives.

Where should I get my car loan?

When it comes to auto financing, it’s a good idea to spend some time shopping around for the best deal for you. You can compare terms from different lenders such as banks, credit unions and other financial institutions to see if their offers can beat your dealer’s.

Who issues car loans?

Generally speaking, there are two ways that you can borrow money to buy a car — direct lending or dealer financing.

  • Direct lending — Direct lenders include banks, credit unions and other financial institutions like online lenders. Borrowing from one of these lenders can give you the opportunity to comparison shop for the best loan terms for you and may give you the option to get preapproved for a specific loan before you shop. And when you’re ready to buy, you’ll use this loan to pay for the car.
  • Dealership financing — This option, which is handled by your dealer’s finance department, makes it convenient to shop for your vehicle and auto loan in one place. Dealers generally have relationships with multiple lenders, so you may be able to compare terms and may even qualify for manufacturer-sponsored low rate or incentive programs. But be on the lookout for “buy here, pay here” dealers offering high-interest in-house auto loans to buyers who don’t have great credit.

If you don’t want to take out a traditional auto loan or don’t qualify for approval, consider asking a family member to help you out or waiting until you’ve saved up enough cash. You can also look into an alternative loan option, like a personal loan from a peer-to-peer lender.

Requirements for applying for a car loan

To receive a car loan, you’ll typically have to complete a loan application that provides information about your financial situation. You’ll probably need the following information handy to make the process go smoothly:

  • Social Security number
  • Current and past addresses
  • Current and past employment information
  • Total income and income sources
  • Information on any other debt you may have

Generally, the approval process includes checking your credit scores and may start with a prequalification. This can result in a soft pull of your credit, meaning it won’t affect your credit scores. If you’re preapproved and you move forward with a full application, the lender will typically pull a hard inquiry on your credit, which can cause a dip in your credit scores. And even if you prequalified, your loan terms and approval may differ when you submit a full application. But as long you do all of your loan comparison shopping in a short window of time, there will be little negative impact on your credit.

If something goes wrong, can someone else take over a car loan?

The short answer is: probably not in an official capacity, but it may be worth checking with your lender. If your lender allows for it, the person assuming the loan will likely have to go through the process of applying for the loan — credit check and all. That means they will likely end up with a new loan rather than actually taking over your loan.

Why all the extra paperwork? The lender wants to make sure that whoever takes on the loan will be able to pay for it. And keep in mind, if your lender allows you to do this, the car no longer belongs to you.

Perhaps you could persuade a kindhearted family member or friend to cover the payments temporarily until you get back on your feet and you can pay them back. But remember that missed payments could result in your car being repossessed. And, crucially, the loan would still be in your name, which means the default would also belong to you. 

If you’ve fallen behind, here are some other options you could consider before you default.

  • Talk to your lender. You could potentially request an extension on your due date or ask for a payment extension or deferral.
  • See if you can work out a repayment plan.
  • Try to refinance the loan at a lower interest rate.

Next steps

Before diving into an auto loan, it’s a good idea to check your credit scores and look at your monthly budget to see if you can afford to make a monthly car payment. If your credit isn’t great, you may want to consider applying with a cosigner or researching lenders that work with low-credit borrowers.

Think about how much you may be able to afford toward a down payment and decide if you want to trade in a vehicle to help lower the total cost of the loan. And if you might be interested in optional add-ons like service contracts, credit insurance or extended warranties, research how these can affect the total cost of your loan.

If you decide to take out a loan, make sure all the paperwork is properly signed before driving away in your new car and always make your payments on time.


About the author: Sarah Archambault is a freelance writer based in New England. She enjoys learning new ways to spend money wisely and helping others figure out how to make smart financial decisions. Sara… Read more.