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What Is an Auto Loan and How Does Financing a Car Work?

Cars are expensive — thank you, Captain Obvious — so most buyers finance them. But that adds a whole new set of wrinkles to the car buying process. 

To smooth them out, make sure you know the pitfalls and potholes to avoid when shopping for auto loans, such as taking a more expensive longer-term loan because the monthly payment is lower. 

Otherwise, you might just get “taken for a ride” on your next car purchase.

What Is an Auto Loan?

An auto loan lets you borrow money to buy a car, truck, motorcycle, SUV, or specialty vehicle. Yes, including those goofy motorized trikes you occasionally see on the road. 

The lender puts a lien against your vehicle to secure the loan. That means that if you default on your monthly payments, the lender can send the “repo man” to repossess your car. 

But that comes with an upside as well: a secured loan costs less, since it reduces risk for the bank. Lenders always price loans based on risk, so taking collateral lets them charge more competitive interest rates. That’s why car loans tend to cost less than personal loans, for example. 

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Key Terms to Know

You can get bogged down in the alphabet soup of APRs and LTVs when shopping for loans. It helps to go in knowing the lingo so you don’t get lost before you begin. 

  • Interest Rate: The interest rate shows how much interest the loan will cost you. It’s expressed as an annual rate. 
  • Annual Percentage Rate (APR): The APR tells you how much a loan costs you per year, adding together both interest and fees. The APR is usually slightly higher than the interest rate
  • Loan Term: This is the repayment period over which you’ll pay back the loan. 
  • Monthly Payment: This is how much you owe in loan payments each month, without incurring extra fees. Bear in mind you can pay extra to pay off your loan faster.
  • Principal Amount: This is your initial loan balance, or the total amount of money you borrow to buy the car. It shrinks over time as you pay down your loan. 
  • Down Payment: This is how much cash you bring to the table when buying a car. 
  • Loan-to-Value Ratio (LTV): This is the percentage of the car’s initial value that the bank will lend you. You can think of LTV as the inverse of the down payment: If you have to put down 10%, that means the lender is fronting you 90% of the purchase price. Your LTV is therefore 90%. 
  • Total Cost: The total amount that a loan will cost you, including interest and fees, over the entire life of the loan. 

How Auto Loans Work

When you buy a car, you can borrow most of the cost with an auto loan and typically pay it back over a three-to-six-year loan term. The longer the loan term, the lower your monthly payment, but you’ll pay more in total interest. As a general rule, you want to borrow the shortest car loan possible

For example, if you borrow a $30,000 auto loan at 5% interest for three years, you’ll pay $2,369 in total interest. A five-year auto loan on the same principal costs you $3,968 in total interest. 

Longer loans typically come with higher interest rates. In all likelihood, you’d end up paying even more in interest on the five-year loan example above. 

Like mortgage loans, you can also refinance a car loan. That can help you score a lower interest rate or monthly payment, but often extends your debt horizon — how long you’ll be paying off the debt. 

Once you do eventually pay off your auto loan, the lender removes the lien against your car and sends you a copy of the removed lien. You then own your automobile free and clear, just in time to start worrying about expensive car repairs.

Types of Car Loans

Most people borrow auto loans from one of two sources: car dealerships or direct lenders. 

Car dealerships sometimes give you a choice between sweetheart financing terms or a discount on the car. In most cases, it makes more sense to take the discount. 

In a perfect world, you’d take the discount and buy the car with cash. But if you can’t afford to buy in cash, you still have plenty of other options for car loans beyond the dealer. 

Direct loan options include banks, credit unions, online lenders specializing in auto loans, and other financial institutions. Shop around for loan offers from your own bank, a few local credit unions, and a few online lenders. 

When shopping around and negotiating rates, don’t let lenders run a hard inquiry on your credit report until you choose a lender. Give lenders your credit score verbally, after you check your own credit. Once you pick one, you can then officially submit a loan application. 

If your credit history has a few dents and scratches on it, invest some time to improve your credit. You can save hundreds or thousands on life-of-loan interest with a higher credit score and lower interest rate.  

Lastly, note that you can take out an auto loan for used cars, not just new cars. Just beware that you’ll pay higher interest rates for used car loans. 

How to Choose a Car Loan

At the risk of stating the obvious, you should always shop around for the lender with the lowest interest rate and fees. 

Well, almost always. Dealerships sometimes offer cheap or even 0% APR financing as a promotion incentive rather than discounts on the selling price. But you’re often better off taking a discount on the car rather than the cheap financing, then borrowing money from the cheapest direct lender you can find. 

Run the numbers through an online calculator to determine the life-of-loan interest, and compare that to the discount. Choose the option that saves you the most total money. 

As a general rule, avoid the temptation of longer-term loans and opt for the shortest loan you can afford. Finally, make sure you get a list of all fees from each lender, so you don’t get sandbagged when you sign on the dotted line. 

Auto Loan FAQs

Financing cars and trucks comes with its own complications, and borrowers often have questions. These rank among the most common, so review them before heading to the dealership. 

Is It Better to Get an Auto Loan From a Direct Lender or a Dealership?

In general, direct lenders tend to offer better loan pricing. Car dealers often work with lenders and earn a commission on loans, which means you can pay extra for the middleman. 

But you should always run the numbers yourself with an auto loan calculator. Compare the life-of-loan costs of a direct lender loan against any promotional discount you might receive on the car. Dealers often offer cheap financing or promotional discounts, but not both.

What’s a Typical Auto Loan Rate?

Car loan rates vary based on benchmark index rates such as the Fed funds rate or the LIBOR, just like mortgage rates. I’ve seen auto loan rates as low as 3%, but they can go into the double digits when interest rates rise. Your credit history also impacts the interest rate that lenders can offer you.  

What Credit Score Do You Need to Buy a Car?

Even borrowers with bad credit can sometimes secure an auto loan. They’ll just pay sky-high interest on it. 

For a decent interest rate, aim for a credit score of 660 or higher. Also bear in mind that the higher your credit score, the higher the LTV that lenders will offer you. 

Is It Better to Choose a Lower Monthly Payment or a Shorter Loan Term?

A shorter loan term saves you money on interest, both in the form of lower rates and lower life-of-loan interest. So, aim to buy a car with the shortest loan term you can afford. 

What Happens When You Pay Off Your Car Loan?

After you write your final check or send in your final ACH payment, the lender removes the lien against your car and sends you a copy of the lien release. You’re then free to play demolition derby if you like — although, financially speaking, you’re better off selling or donating your car than blowing it up. 

Final Word

Buying a car is exciting and a little scary. Unfortunately, getting a loan adds extra “scary” without adding more excitement. 

But the process is simple enough, and you can save money by shopping around and negotiating the terms of your car loan. Aim to compare rates and terms from at least five lenders and negotiate with each of the finalists. 

Check your credit before moving ahead too. If your credit report looks rustier than your teenage beater, consider asking a relative or very close friend to co-sign your loan with you. 

If getting a cosigner isn’t an option, you can potentially give your credit score a quick boost by paying your credit card balances down below 30% of your card limits. If you can pay off your balances in full, all the better, both for your credit score and avoiding interest. 

G. Brian Davis is a real estate investor, personal finance writer, and travel addict mildly obsessed with FIRE. He spends nine months of the year in Abu Dhabi, and splits the rest of the year between his hometown of Baltimore and traveling the world.