What An Auto Loan Is And How It Works

If you want to get behind the wheel of a vehicle, you must first arrange for vehicle financing. An auto loan is simply money you borrow to pay for the vehicle. Auto loan terms vary, so it is important to understand the process to get the best auto loan possible. Auto loan details vary, which means getting the right loan could save you hundreds or thousands of dollars over time. Understanding the process can help you get the best auto loan possible.

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

If you have a high credit score, you may be able to qualify for a lower interest rate, which will save you money over time. Your credit score also helps determine the initial loan amount and required down payment.

Terms to know

Interest rate: This is the annual fee the lender assesses to borrow the funds needed to buy the vehicle. A higher credit score or shorter loan term generally equates to a lower interest rate.
Annual percentage rate (APR): The APR is the total borrowing cost of the loan, including the interest rate and other fees, expressed as an annual percentage.
Down payment: You will pay this amount to the lender before taking out the loan. It will be applied toward the total purchase price. The more you put down, the lower your monthly payments will be.
Loan term: The loan term or repayment period is the window of time during which you’ll make payments on the auto loan.
Principal: This is the amount you’re borrowing to purchase the vehicle minus the interest and fees. The principal plus the down payment equals the cost of the car.
Total cost of the loan: This figure includes the principal, interest and fees paid to acquire the vehicle.

Auto loans come in a few varieties, including dealer financing, car loans from banks or credit unions and loans from online lenders.

The type of loan that’s best for you depends on factors like your credit score, the loan amount and the vehicle you want.

Dealer financing

Dealer financing is the easiest type of loan to get since you can do your shopping and financing in one spot. The dealer will likely check your credit. If you have a strong credit score, you may qualify for a promotional rate from the manufacturer if you go through a certified dealership.

But 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

You can also apply for a car loan at a traditional bank or credit union. The lender funds these loans, so you won’t have to go through a dealer. However, it may take more time than going through a dealership. Expect it to take at least one business day to get a loan from a bank or credit union, up to a week.

Lenders often have a minimum and maximum loan amount, so be sure the lenders you’re looking into offer the amount you need for your new car.

Online auto loan

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

Like mortgages, the best way to compare auto loans is to look at the key costs — including interest rate, term and fees — along with the estimated monthly payment and the total payments over the loan term.

Annual percentage rate (APR)

The APR is one of the most important numbers when deciding on a loan, as it determines total borrowing costs. It’s 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. However, a shorter-term loan or higher credit score means you’ll likely have access to better rates. The lender will also factor in additional fees, so review the loan’s structure.

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.

To illustrate, imagine you get a 48-month, $36,000 auto loan with a 6 percent interest rate. The monthly payment will be $845, and you’ll pay $4,582 in interest over the loan term. But if your rate is 8 percent, you’ll pay $879 per month and $6,186 in interest for the duration of the loan.

Term

You have a set number of months to repay your auto loan. 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 — but you’ll pay more interest over time and be charged a higher interest rate. To save that money, take out a shorter term. Just make sure the payments are well within your budget.

For example, a $25,000, 36-month loan with an interest rate of 5 percent will cost you $749 per month and $1,974 in interest. A loan for the same amount and interest rate with a 60-month term has a far lower monthly payment of $472, but the interest costs are $3,307 — a difference of $1,333.

Fees

Think of your auto loan fees like any other fees you pay to purchase a car. The two main fees you need to review include the origination fee and the documentation fee. The origination fee is the amount you pay to secure the loan. The documentation fee will cover the lender’s costs for securing your loan.

The key to securing an auto loan is to be prepared with your finances and to shop around for rates. You should also go to a dealership with a preapproved loan option.

1. Do your homework

Don’t wait until you’re ready to buy a car to learn about auto loans. Start with the basics, such as your credit score and what your current financial situation looks like.

Gain a good understanding of your budget to see how much car you can afford. Check your credit reports: Non-mortgage debts and delinquencies are not the only factors that hurt your credit. Credit utilization rates of over 30 percent on your revolving accounts could also mean bad news for your score.

Consider paying down delinquent accounts if possible, and dispute any errors you find on your credit reports. You should also research the average interest rate and monthly payments on car makes and models. Think about how long you plan to keep your car and whether new or used works better for you.

Bankrate tip

Use an online auto loan calculator to estimate your monthly payments and available interest rates based on the car you’re considering and your credit profile.

2. Get preapproved

Preapproval involves filling out forms with banks, credit unions or online lenders to get an idea of the rates they can offer you. Getting preapproved for a loan before heading to the dealership gives you negotiating power.

Consider using a co-signer if you’re struggling to get preapproved for an auto loan. Your co-signer should have a good credit rating and a steady source of income to give you the best chance at qualifying for a loan.

Bankrate tip

When you apply for preapproval, you will often only have a shopping period of at least 30 days after. Use that time to find the car that best fits your needs.

3. Shop around

Once you’ve secured a loan, it’s time to shop around for a car. Use numbers you’ve been given — which include the interest rate, monthly payment, amount and loan term — to inform your comparison shopping.

Currently, it’s difficult to get out with anything below the sticker price, but that doesn’t mean you shouldn’t try to negotiate.

Bankrate tip

As you look at vehicles, keep an eye out for salespeople who pressure you to make a deal that doesn’t serve you. Never be afraid to walk away from a bad deal.

4. Make the deal

The moment you find the car you want, ask for the dealer’s financing offer and compare it to the deals you’ve already locked down. Avoid being rushed when you’re signing paperwork, and read everything you sign.

Bankrate tip

Beware of dealer add-ons you don’t need. You can often avoid them altogether or get them for much less outside the dealership.

The bottom line

Simply, 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 getting a personal loan, it is still possible to do it yourself and land a good deal. It just takes time and research.

FAQs about auto loans

To transfer a car loan to another person, you have two options. The most straightforward is to sell the car to the other person, who then takes out a private-party auto loan to pay off the lender. Alternatively, you can refinance the loan in the other person’s name. In this case, both you and the co-signer must sign the loan. The car’s title will be updated with the co-signer’s name alongside yours. You will then have to refinance again to remove your name from the loan and title. It’s best to only attempt this if significant time has passed since the car was last refinanced, due to the potential negative impact on your credit score. If you decide to refinance, it’s best to have a co-signer with a high credit score and income to improve the chances of approval.
Though loans on new and used cars work the same way, the details can differ. Pre-owned car loans typically have higher APRs than new car loans, but the loans often have shorter repayment terms. This means that, while you’ll pay more in interest, you’ll also get to the point of being car payment-free sooner. In many cases, pre-owned car loans may be more accessible to a broader range of credit types than new car loans. In addition to being easier to get approved for, pre-owned car loans may also have lower down payment requirements. And because used cars typically cost less than new vehicles, loans for pre-owned cars tend to be for smaller loan amounts than new car loans.
Auto loans and leases are different. An auto loan involves buying a car and making payments until the loan is paid off. A lease involves renting a car and making payments over time until the lease is up. At the end of a loan, the buyer owns the car. But at the end of a lease, the lessee has to either return the car or buy it.

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