What An Auto Loan Is And How It Works

If you want to buy a car without paying entirely in cash, you must apply for vehicle financing. An auto loan is the money you borrow to pay for the vehicle. It includes the vehicle’s purchase price, interest and any applicable fees.

Comparing your options and getting the right loan could save you hundreds or even thousands of dollars. Understanding the key terms of an auto loan will help you do just that.

What is a car loan?

An auto loan is a type of installment loan that allows you to borrow money from a lender to purchase a car. You’ll repay the loan in fixed installments over a set period, and interest will be charged on the money you borrow.

Your credit scores help determine the down payment you need to make and the loan amount you can borrow. A score in the mid-600s or higher may qualify for a lower interest rate, saving you money.

Those with a bad credit score may have more trouble securing an auto loan with competitive rates. Lenders tend to view lower credit score borrowers as riskier, resulting in higher rates. If you have a low credit score, consider looking for a bad credit auto loan, which has more lenient acceptance criteria. You can also wait to buy a car until you improve your credit score.

How does an auto loan work?

Once you compare auto loan rates, apply and get approved, you will receive a lump sum to purchase the vehicle. Following that, you will make monthly payments to repay the loan, plus interest and fees. If you do not repay the loan, you risk losing the vehicle, as it serves as collateral.

The best way to ensure you will be able to repay your loan is to start with an auto loan calculator. By entering different loan amounts, terms and interest rates, you can determine how much you can afford for your monthly payment.

You can also control the cost of your auto loan by:

• Researching lenders and using prequalification to compare multiple offers.
• Choosing a less expensive vehicle.
• Making a large down payment.
• Paying taxes and fees upfront rather than financing them.
• Choosing a shorter loan term.
• Making additional car payments.
• Avoiding unnecessary add-ons.

Lenders set interest rates based on credit score, which means the type of loan that’s best for you depends on your scores, the loan amount and the vehicle you want. Lenders typically like to see regular income, a low debt-to-income (DTI) ratio and a good credit score. The stronger your credit score is, the more competitive your rate will be.

Types of auto loans

There are three financing options to choose from: dealer financing, car loans from banks or credit unions and loans from online lenders.

Dealer financing

Dealer financing is the easiest way to get an auto loan, but not always the most cost-effective. You can do your shopping and financing in one spot. The dealer will likely perform a hard credit check. If you have a strong credit score, you may qualify for a promotional rate from the manufacturer if you go through a certified dealership.

However, dealer financing tends to come with a higher interest rate. Dealers often take a commission or markup when they match you with financing from a bank or credit union.

Bank or credit union auto loan

Traditional banks and credit unions offer auto loans if you don’t want to go through a dealer. However, it may take more time than going through a dealership. Generally, expect to wait between one business day and a week to get a loan from a bank or credit union.

It may be easier to qualify for an auto loan if you go through your regular bank or credit union. You may also qualify for a discounted rate. Typically, credit unions offer some of the lowest rates available.

Online auto loan

You can also apply for an auto loan through an online lender. These loans are often processed remotely, but the steps are similar to getting a car loan from a bank or credit union. It can take less than one business day to get approved, depending on the lender.

Online lenders may also be more likely to work with borrowers with subpar credit scores. Some even offer favorable bad credit auto loan rates, although like any lender, it will depend on your finances.

How to compare auto loans

The best way to compare auto loans is to look at the key costs — including interest rate, term and fees. Look at both the estimated monthly payment and the total paid over the loan term.

Annual percentage rate

The APR is one of the most important numbers when deciding on a loan. It determines total borrowing costs. An APR is set based on your credit score, income and the term and amount of the loan.

Expect a higher interest rate if you’re in the market for a longer-term loan or if your credit score is fair or poor. A shorter loan term or higher credit score may help you access better rates. Ideally, you want a lower APR to get a more affordable monthly payment and keep more money in your pocket. An APR just a few points higher could make the loan far more expensive.

The average new car loan rates range from 5.18 percent for borrowers with excellent credit and 15.81 percent for borrowers with poor credit, according to Experian’s most recent State of the Automotive Finance Market report. To illustrate, this is the monthly payment and total interest paid on a $36,000 auto loan with a 48-month term. We’ve broken it down by credit score to show how your credit score influences your APR and the amount you pay to finance a car.

Term

You have a set number of months to repay, which makes managing your auto loan important. A typical auto loan term ranges anywhere from 36 to 84 months.

If you plan to purchase a new car and keep it for a long time, you’ll owe a lower monthly payment by taking out a longer-term loan compared to the average car loan length. But you’ll pay more interest over time and be charged a higher interest rate. To save, choose a shorter term. Just make sure the payments fit your budget.

For example, assume you’re approved for a $36,000 loan with an interest rate of 6 percent. Take a look at the payments and interest costs for different loan terms:

Fees

The fees you pay when buying a car can vary. That’s because some fees are required by your state and local government, while others cover the dealer’s costs. Some dealerships charge more fees than others, so you may need to negotiate them as part of your car purchase. You can also pay the cost of fees upfront rather than rolling them into the cost of your loan to save money.

Expect to pay sales tax, title and registration fees. These are required and often handled by your dealer. In addition, dealers may require you to pay origination and documentation fees to cover the cost of processing your loan paperwork. They may also try to charge you negotiable fees, such as:

• A prepayment penalty.
• Extended warranty and service contract fees.
• Gap insurance.
• VIN etching.
• Fabric or paint protection.
• Credit report fee.
• Advertising fee.
• Destination charge for shipping your vehicle to you.

Bottom line

A car loan is an agreement between the lender and you, the borrower, allowing you to borrow money for an agreed-upon term to purchase a vehicle. While getting a car loan can be more complex than a personal loan, it is still possible to do it yourself and land a good deal. It just takes time and research.