How Auto Loans Work – Financial Help to Own Your Dream Car
Joy Wallet is advertiser-supported: we may earn compensation from the products and offers mentioned in this article. However, any expressed opinions are our own and aren't influenced by compensation. To read our full disclosure, click here.
If you are interested in buying a car, there are two things you need to do: Find a car and look for a loan to pay for it. You might not have enough savings to make a payment upfront, so you will have to borrow from a lender.
Auto loans are easily available from banks and financial institutions, and in this guide, we explain how auto loans work. Auto loans can be confusing and overwhelming if you are a first-time buyer. The better you understand how it works, the better you can negotiate.
In this article
What is an auto loan?
An auto loan is specifically designed for purchasing a vehicle, such as a car, truck, or motorcycle. It is a form of installment loan where the borrower receives funds from a lender to finance the purchase of the vehicle and then repays the loan over a predetermined period of time, typically in monthly installments.
Banks, credit unions, and financial institutions commonly provide auto loans. The loan amount is based on the total cost of the vehicle minus any down payment made by the borrower. The interest rate on the loan is determined by various factors, including the borrower's creditworthiness, the loan term, and prevailing market rates.
When a borrower takes out an auto loan, the vehicle serves as collateral for the loan. If the borrower fails to make payments as agreed, the lender has the right to repossess the vehicle to recover the outstanding debt. Once the loan is fully repaid, the borrower becomes the outright owner of the vehicle.
Auto loans can be secured or unsecured. Secured auto loans require collateral, which is the vehicle being financed, while unsecured loans do not require collateral but often have higher interest rates. The loan term can range from a few years to several years, with longer terms resulting in lower monthly payments but potentially higher overall interest costs.
Use Quicken Loans to Get a Personal Loan
- If you're tight on cash right now, you may want to consider getting a personal loan. A personal loan is a loan that you can use for just about any purpose like: paying off other debt, renovating your home, or family needs like a wedding or adoption.
- TrustPilot Rating 4.6 out of 5
- Connect with lenders for $0
- 100% online experience.
How does an auto loan work?
Auto loans provide individuals with the funds they need to purchase a vehicle while allowing them to repay the loan over a specified period. Here's a step-by-step breakdown of how an auto loan typically works:
- The borrower selects the desired vehicle they want to purchase. They consider the make, model, year, price, and vehicle condition.
- The borrower applies for an auto loan from a bank, credit union, or financial institution. The application process involves providing personal and financial information, including income, employment details, credit history, and the desired loan amount.
- The lender reviews the borrower's application, creditworthiness, and the details of the financed vehicle. If the borrower meets the lender's criteria, the loan is approved, and the terms and conditions, including the interest rate, loan amount, and repayment schedule, are determined.
- The borrower may be required to make a down payment towards the vehicle purchase. The down payment is a portion of the total vehicle price paid upfront, reducing the loan amount and often improving the borrower's chances of loan approval.
- Once the loan is approved, the lender disburses the funds to the borrower or directly to the dealership or seller of the vehicle. The borrower becomes the vehicle's owner, while the lender holds a lien on the vehicle's title until the loan is fully repaid.
- The borrower repays the loan in regular installments over the agreed-upon loan term, typically monthly. Each installment includes the principal (the amount borrowed) and interest (the cost).
- Once the borrower completes all the required payments, including principal and interest, the loan is fully repaid, and the lender releases the lien on the vehicle's title. The borrower becomes the outright owner of the vehicle.
Related: Your Car Is Totalled. Now What?
How much does an auto loan cost?
The cost of an auto loan depends on various factors, including the loan amount, interest rate, loan term, down payment, and any additional fees or charges. Here are some components that contribute to the overall cost of an auto loan:
Principal amount
The principal amount is the total loan amount borrowed to finance the vehicle. The higher the loan amount, the more you will need to repay.
Interest rate
The interest rate is the cost of borrowing money and is expressed as an annual percentage rate (APR). The interest rate can vary based on your creditworthiness, loan term, and prevailing market rates. A higher interest rate means you will pay more interest charges over the life of the loan, increasing the total cost.
Loan term
The loan term refers to the length of time over which you repay the loan. Longer loan terms typically result in lower monthly payments but can lead to higher overall interest costs. Shorter loan terms may have higher monthly payments but can save you money on interest charges.
Down payment
The down payment is the initial amount paid upfront towards the vehicle purchase. A larger down payment reduces the loan amount, which can lower the monthly payments and the total interest paid over the loan term.
Additional fees
Lenders may charge additional fees, such as origination, documentation, or prepayment penalties. These fees can vary among lenders and add to the loan's overall cost. It's important to review and understand any fees associated with the loan carefully.
Where should you apply for an auto loan?
There are two ways you can borrow money to purchase a car- one is direct financing, and the other is dealer financing.
Direct financing
You can get an auto loan from a bank, financial institution, or credit union. You get a chance to compare the loan terms and then make a decision. You also have the option to get preapproved for a loan before you apply. You could enjoy discounts at the rate if you already have a bank or credit union account.
Dealer financing
A common form of financing a vehicle purchase is dealer financing. The dealership will handle the entire process, which has a financial contract with the lenders. In this case, you do not have a chance for negotiation, but the process is quicker, and you do not have to worry about handling the documentation or contacting multiple lenders. However, they might not have the best terms.
Related: Auto Loan vs. Dealer Financing
Use Quicken Loans to Get a Personal Loan
- If you're tight on cash right now, you may want to consider getting a personal loan. A personal loan is a loan that you can use for just about any purpose like: paying off other debt, renovating your home, or family needs like a wedding or adoption.
- TrustPilot Rating 4.6 out of 5
- Connect with lenders for $0
- 100% online experience.
How to choose the best auto loan?
Choosing the best auto loan requires careful consideration of several factors. Here are some steps to help you select the most suitable auto loan for your needs:
Assess your financial situation
Start by evaluating your current financial status. Determine how much you can borrow and repay monthly without straining your budget. Consider your income, expenses, and other financial obligations to establish a realistic loan amount and monthly payment range.
Check your credit score
Obtain a copy of your credit report and check your credit score. A higher credit score generally improves your chances of getting approved for a loan and qualifying for better interest rates. If your credit score is lower, you may want to improve it before applying for an auto loan, as this can help you secure more favorable loan terms.
Compare interest rates
Shop around and compare interest rates from different lenders. A lower interest rate can save you a significant amount of money over the life of the loan. Consider both banks and credit unions, as they may offer competitive rates. Online lenders and financial marketplaces can also provide options to explore.
Evaluate loan terms
Look closely at the loan terms offered by different lenders. Consider the loan duration (term) and how it affects your monthly payments and overall interest costs. While longer terms may offer lower monthly payments, they can increase interest charges over time. Shorter terms can lead to higher monthly payments but may save you money on interest.
Review additional fees and charges
Pay attention to any additional fees or charges associated with the loan. Common fees include origination fees, prepayment penalties, or documentation fees. Ensure you understand the total cost of the loan, including these fees, to make an accurate comparison between lenders.
Evaluate down payment requirements
Consider the down payment requirements of various lenders. A larger down payment can reduce the loan amount, resulting in lower monthly payments and potentially better loan terms.
Read the fine print
Carefully review the terms and conditions of each loan offer. Look for hidden fees, prepayment penalties, or other clauses affecting your borrowing experience. Ensure you understand the repayment schedule, late payment policies, and any consequences of defaulting on the loan.
Seek pre-approval
Consider obtaining pre-approval from a few lenders. Pre-approval provides an estimate of the loan amount you may qualify for and the interest rate you can expect. Preapproval can give you more confidence when negotiating with dealerships and streamline car buying.
If needed, consult with a financial advisor or loan specialist who can guide you based on your circumstances. They can help you understand the terms, compare options, and make an informed decision.
Related: Best Auto Loans
Use Quicken Loans to Get a Personal Loan
- If you're tight on cash right now, you may want to consider getting a personal loan. A personal loan is a loan that you can use for just about any purpose like: paying off other debt, renovating your home, or family needs like a wedding or adoption.
- TrustPilot Rating 4.6 out of 5
- Connect with lenders for $0
- 100% online experience.
Pros and cons
Pros
- Vehicle Ownership. Auto loans allow you to purchase a vehicle even if you don't have the full amount upfront. You can enjoy the benefits of owning a car and have full control over its use.
- Convenient Financing. Auto loans provide a convenient way to finance the purchase of a vehicle. Instead of saving up for years to buy a car outright, you can spread the cost over time and make affordable monthly payments.
- Credit Building. Successfully managing an auto loan can help establish or improve your credit history. Making timely payments demonstrates responsible financial behavior, which can positively impact your credit score and make it easier to obtain future loans at favorable terms.
- Flexibility in Loan Terms. Auto loans offer flexibility in terms of loan duration. You can choose a shorter term to pay off the loan quickly, saving on interest, or opt for a longer term to have lower monthly payments.
Cons
- Debt and Interest Charges. Taking on an auto loan means adding debt to your financial obligations. You'll be responsible for repaying the loan amount along with interest charges, which can significantly increase the total cost of the vehicle.
- Depreciation. Vehicles typically depreciate over time, meaning their value decreases. If you owe more on the auto loan than the vehicle is worth, you may find yourself in a situation where you have negative equity, making it challenging to sell or trade-in the vehicle without incurring additional costs.
- Risk of Repossession. When you take an auto loan, the vehicle serves as collateral. If you fail to make timely payments, the lender has the right to repossess the vehicle. Losing the vehicle can have significant financial and practical implications.
- Interest Rates and Fees. The interest rates on auto loans can vary depending on factors such as your creditworthiness, loan term, and prevailing market rates. Higher interest rates can result in more expensive monthly payments and increase the overall cost of the loan.
FAQs
Is it cheaper to buy or rent a car?
Buying a car is a long-term commitment and you will have to continue paying the loan for a few years. You will also have to budget for the same. On the other hand, renting a car is much cheaper and you can end the rent agreement if you are unable to pay the monthly rent.
Which is the fastest way to get an auto loan?
You can get an auto loan quickly through dealer financing. This is because the dealers have relationships with the financiers and they can handle the negotiation and documentation quickly.
Is insurance a mandatory requirement for an auto loan?
Most lenders will require you to have full coverage all year round until the loan amount is paid off.
The bottom line
Lenders will offer multiple options for you, but the loan should work for your financial situation. Do not apply for a loan with the first lender you come across; research and compare the options. Ultimately, you need a loan that fits into your monthly budget. Reading the fine print and understanding how the loan works will help you make the right decision.
Joy Wallet is an independent publisher and comparison service, not an investment advisor, financial advisor, loan broker, insurance producer, or insurance broker. Its articles, interactive tools and other content are provided to you for free, as self-help tools and for informational purposes only. They are not intended to provide investment advice. Joy Wallet does not and cannot guarantee the accuracy or applicability of any information in regard to your individual circumstances. We encourage you to seek personalized advice from qualified professionals regarding specific investment issues. Featured estimates are based on past market performance, and past performance is not a guarantee of future performance.
Our site doesn’t feature every company or financial product available on the market. We are compensated by our partners, which may influence which products we review and write about (and where those products appear on our site), but it in no way affects our recommendations or advice. Our editorials are grounded on independent research. Our partners cannot pay us to guarantee favorable reviews of their products or services.
We value your privacy. We work with trusted partners to provide relevant advertising based on information about your use of Joy Wallet’s and third-party websites and applications. This includes, but is not limited to, sharing information about your web browsing activities with Meta (Facebook) and Google. All of the web browsing information that is shared is anonymized. To learn more, click on our Privacy Policy link.
Images appearing across JoyWallet are courtesy of shutterstock.com.
Share this article
