How Do Car Loans Work: A Useful Guide

A car is one of the largest purchases you’ll make in life. With the average cost of new cars well over $48,000, most people have to rely on loans to finance their purchases.

Before you visit the dealership to pick out your next car, it's important to research your financing options. So, how do car loans work? In this guide, we’ll talk about important terms you should know, how to apply for a loan, and how to manage your payments so you don’t end up with a lot of car debt.

What Is a Car Loan?

If you want to buy a new or used car and don’t have the funds to pay for it all at once, you’ll need a loan. So, what is an auto loan? An auto loan involves borrowing money from a financial institution to purchase a car. You agree to pay back the amount you borrow, along with interest and fees accrued, over a set period of time.

A car loan is an installment loan with a legally binding agreement between the lender and you. You’ll have fixed car loan payments, the amount of which will depend on how much you’ve borrowed, down payment, interest rate, and loan term.

Longer loan terms, like 60 months, can make your payments lower. However, you may end up paying more in interest over the life of the loan. So, how do auto loans work with different terms? Let’s compare two options for a $30,000 loan at an interest rate of 5.89%.

What You Should Know About How Car Loans Work

How does a car loan work? As you research car loans, it's important to understand the key terms you’re likely to come across.

Duration

The duration of the car loan or the repayment term is the amount of time you have to repay the loan. So, how long are car loans? Auto loan terms typically range from 24 months to 84 months.

If you want to keep your interest costs, it's best to choose the shortest term. Many lenders also offer better rates on shorter terms. When choosing the loan term, it's also essential to keep affordability in mind. Check your budget to make sure you’ll be able to afford the loan installment for the duration of the loan.

Down Payment

This is the amount you’ll pay upfront for the car. You can then take out a loan for the remainder of the amount. How much should you put down on a car? Ideally, you should put down 10% to 20% of the vehicle’s purchase price.

While you may be able to get a no-down payment car loan, the more you can put down, the less money you’ll need to borrow and the less you’ll pay in interest.

Interest Rates

Interest rates on car loans change daily, so it's best to check the current loan rates before you visit a dealership. You may also want to get pre-approval for an auto loan to know what interest rate you qualify for.

Car loans use simple interest, not compound interest rates. When shopping for a car loan, it’s also important to look at the annual percentage rate (APR), which includes the interest as well as any fees you’ll need to pay on the loan. This will give you a better understanding of the true cost of the loan.

Monthly Payments and Other Options

Your monthly payment is the amount you must pay for a car loan each month. A portion of this payment will go toward interest; the rest is applied to the principal. You may also choose bi-weekly payments for the loan.

Another option is to choose a balloon payment for your loan. With this option, your lender will offer you a repayment schedule of smaller monthly payments and a final larger lump-sum payment called the balloon payment. This payment can be thousands of dollars and may often be half of the vehicle’s value.

A balloon payment makes sense if you want lower monthly payments and are sure you’ll be able to handle the larger balloon payment when your term ends.

Loan Collateral

Auto loans are secured, which means that the vehicle you’re purchasing is collateral for the loan. When you finance your car, you’ll get full ownership of the vehicle once you’ve paid off the loan. If you fail to make loan payments, the lender can repossess the car to recover the money you owe.

How To Apply for an Auto Loan

Now that we’ve discussed how car loans work, let’s take a look at how to apply for one.

1. Prepare Your Documents

To get a car loan, you’ll need to fill out a loan application and submit some documents, such as:

• Social Security number
• Pay stubs
• Income tax returns
• Identification proof
• Proof of address

Make sure you have the necessary documents on hand to ensure the process goes smoothly. The lender will start with a prequalification, and there’ll be a hard inquiry on your credit report if you move forward with the application.

Requirements to Apply for a Car Loan

To get approved for a car loan, here’s what you’ll typically need.

Good Credit Score

Most lenders require a 670 or higher credit score for a car loan. It’s a good idea to check your credit score before you apply to see if you qualify. You may qualify for a lower interest rate if your credit score is high.

Some lenders also provide car loans with bad credit, but you’ll typically pay higher interest rates on these loans.  

Reliable Income

You’ll also need to have verifiable income to demonstrate your ability to repay the loan. Lenders will require you to submit copies of tax returns and pay stubs to check your financial situation.

Low Debt-to-Income Ratio

For most lenders, the debt-to-income ratio for car loans should not be higher than 50%. This ratio compares your income against your monthly debt payments to see if you can afford the car loan installments.

2. Research Car Loans

Once you have your documents handy, it’s time to compare the loan options available to you. We recommend prequalifying with at least three different lenders and comparing the interest rates, fees, and repayment terms you qualify for.

It’s also important to check the customer reviews of each lender you shortlist to ensure they’re reliable and trustworthy. Once you have a better idea of what you qualify for, you can start shopping for a car.

How To Manage a Car Loan 

Understanding how car loans work is not enough. You also need to know how to manage your payments and how to get out of a car loan if needed.

Make a Budget

Before you sign the loan agreement, it's important to crunch the numbers to ensure you’ll be able to pay the installments for the entire term comfortably. If the installments stretch your budget, check to see if you can cut back spending in other categories. Making a budget and reviewing it is the best way to manage your expenses.

Find the Lowest Interest Rate

"If your interest rate is high when you apply for a car loan, come up with a bigger down payment and try to refinance after a year for a lower rate,” suggests Teresa Dodson, a financial expert and the founder of Greenbacks Consulting. “If your interest rate is reasonable, shorten the term of the loan as much as you can. Budget ahead of time to pay off the loan as soon as possible with payments you can afford,” Dodson adds.

Pay on Time

An excellent way to ensure you pay the installments on time is through automatic payments. Many lenders offer additional discounts of up to 0.5% for using autopay. This will ensure that you don’t miss payments or accrue late payment fees.

Don’t Stop Payments

Have an emergency fund and a plan in place to manage your loan payments in case of reduced income, job loss, or a medical emergency. Don’t stop paying your loan because it can damage your credit score, and your car may be repossessed.

Take Care of Your Car

Be sure to maintain your vehicle in good condition through regular maintenance and repairs. This will allow you to extend the life of the vehicle so you can continue using it for longer. A well-maintained car can also help slow down depreciation.

Get Insurance

Get adequate insurance for your car to ensure you’re covered in case of an accident. You can also get payment protection insurance to cover payments in case of a disability, job loss, or death.

Is Getting a Car Loan a Good Idea?

Getting a new or used car loan can help you purchase a vehicle that you may otherwise not be able to pay for in cash. However, before you buy a new vehicle, it's important to look at your budget and check your credit history. Compare loan offers from different lenders and use an auto loan calculator to ensure your payments will be affordable.

Consider saving up for a larger down payment and trading in your current vehicle to reduce the amount you have to borrow. Keep in mind that additional services like extended warranties and service contracts can also add to the total loan cost.