How Do Car Loans Work?

Written by Kim PinnelliReviewed by Eric Leider, CFP®, RLP®, BFA™Updated: 4th May 2022
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You need a car, but don’t’ have the cash to buy it. Fortunately, it’s easy to get a car loan, but you should know how they work before you do.

What Is a Car Loan?

A car loan is a secured loan that uses the car as collateral. You can borrow up to the amount of the car’s value. Car loans are available at private banks, online auto loan lenders, and car dealerships. You’ll make monthly payments of principal and interest to the bank that lent you the money, and once you pay the car loan off in full, you’ll receive the title to your car.

How Do Car Loans Work?

A car loan is an installment loan. You make equal payments monthly until the end of the term. Loan terms last from 2 to 7 years. The loan payment depends on how much you borrow, the interest rate, and the term (the length of time you borrow the funds).

The longer your loan term is, the lower your payments. But keep in mind, the longer the term is, the more interest you’ll pay because it will take you longer to pay the debt back.

Car Loan Terms to Know

  • Annual Percentage Rate (APR): The APR is the total cost of the loan displayed as a percentage. It includes the interest you’ll pay for the loan and the lender fees charged for borrowing the money. The better your qualifying terms (higher credit score, shorter-term, etc.), the lower your APR will be.
  • Loan Term: The loan term is how long you must pay the loan back. Most lenders offer 24, 36-, 48-, 60-, and 72-month terms. The longer the term, the more interest you pay and the longer it takes to own the car free and clear.
  • Down Payment: Any money you invest in the car is a down payment. It’s your investment in the car, which also lowers how much money you must borrow, the cost of your monthly payment, and the terms lenders offer.
  • Monthly Payment: This is the amount you pay each month to pay the loan. Every payment includes interest and principal, but some payments may also include fees, such as late fees.
  • Principal: This is the amount you borrow to buy the car. It doesn’t include any interest or other fees. For example, if you borrow $10,000 to buy a car, your principal amount is $10,000.
  • Total Cost: This is the full amount you’ll pay over the life of the loan in principal and interest charges. This number can help you determine if the loan is worth it, and it helps you compare it to other loans.
  • Amortization: This is the process of paying off your loan. Your amortization schedule shows the amount of principal and interest you’ll pay each month. At the start of the loan, you’ll pay more interest than the principal. As you pay the principal down, the interest charges decrease, and eventually, you pay more principal than interest. This usually happens near the end of the loan.
  • Car Taxes: Just like any purchase you make; you’ll pay taxes when you buy a car. The car taxes get added to the purchase price and can be paid for with the loan if you wish.
  • Loan-to-Value Ratio: The LTV compares your loan to the car’s value. The more money you put down on the car, the lower your LTV. Lenders like lower LTVs because they are less risky. The more money you have invested in your car, the less likely you will default on your loan.
  • Interest Rate: This is the rate a lender charges to loan you the money. This isn’t the loan’s total cost as a percentage. It’s best to compare APRs than interest rates to see which loan offers the best deal.

How to Save Money on a Car Loan

Luckily, it’s easy to save money on a car loan if you use the right principles. Here are some simple tips to follow.

#1. Stick to a Budget

Figure out what you can afford and stick with it. Don’t go over budget because you fell in love with a car or think the payment is affordable. Determine what you can afford and make sure any car you consider buying has a payment that is equal to or less than this amount.

>> More: How to Get Preapproved for a Car Loan

#2. Compare Lenders & Rates

Always get at least three quotes for a car loan. If you shop around for a car loan quickly, you won’t hurt your credit. The credit bureaus recognize the need to shop around, so they hit you with one inquiry for all car loan inquiries that occur within a short time.

When you compare offers, look at these factors:

  • Interest rate
  • Fees
  • Loan terms
  • APR

Choose the loan with the lowest APR and the most attractive term. Don’t get caught up in interest rates alone because you could end up paying more for a loan than you realized.

>> More: Best Auto Loan Rates

#3. Make Large Monthly Payments

Most lenders allow you to prepay your loan without a penalty. This means you can make extra payments toward the principal as you want. If you pay the principal down faster, you’ll pay less money in interest, and you’ll own the car faster.

#4. Consider Refinancing Later After Some Time

If you can’t get the best financing terms when you apply for a car loan, consider refinancing your auto loan when your credit is better. A lower interest rate could save you money monthly and over the life of the loan. You can also refinance if you can afford a shorter term to pay the loan off faster, and you’ll save even more money on interest this way.

Who Offers Car Loans?

You can get car loans in many places, but here are the most common.

Dealership Financing

Dealers usually offer financing right there on the spot. You work with the finance manager, a ‘broker’ between you and the banks. Dealerships earn a commission from the bank, so they try to push you to finance with them, but they don’t always have the best deals.

Direct Lenders, Banks, & Credit Unions

If you have good credit, look around for a better car loan option. Banks, credit unions, and online direct lenders are great options for a car loan.

You’ll usually find they have lower interest rates and fees. Plus, if you get financing yourself, you become a ‘cash deal’ at the dealership, which may give you more opportunity for negotiating.

What Are the Requirements for Car Loans?

It’s easy to get a car loan. To qualify, you must provide:

  • Employment and income information
  • Current and past addresses
  • Social Security number
  • Additional information on debts if they ask

Lenders look for stable income, a decent credit score, and an average debt-to-income ratio that shows you aren’t over your head in debt. Most lenders prefer a DTI of 50% or less.

Is Getting a Car Loan a Smart Financial Move?

Cars are a depreciating asset, so it makes sense to wonder if a car loan is a smart move.

The answer is that it can be. It depends on the situation.

If you’re borrowing money to buy a luxurious car and you put little money down on it, then no, it’s not smart. But, if you’re buying a car that you need is reasonable, and you’re putting your own money into the investment, it can be smart.

The key is finding the loan with the best terms and the lowest APR. Why pay more for a car than necessary? Most people can’t pay cash for a car, so they need the financing, and it can be a wise choice if you choose the financing that costs the least and allows you to own the car yourself after a short time.

Bottom Line: How Do Car Loans Work?

Don’t get roped into a bad car loan deal, especially at the dealership. Know what you can afford, compare your options, and find the lender that offers the most attractive loan. If you avoid using a car loan to buy a car you otherwise couldn’t afford, a car loan can be a good way to get the transportation you need!

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Kim Pinnelli
Kim Pinnelli

Kim Pinnelli is a Senior Writer, Editor, & Product Analyst with a Bachelor’s Degree in Finance from the University of Illinois at Chicago. She has been a professional financial writer for over 15 years, and has appeared in a myriad of industry leading financial media outlets. Leveraging her personal experience, Kim is committed to helping people take charge of their personal finances and make simple financial decisions.