What Is A Car Loan & How Do They Work?

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Cars are an important mode of transportation, but few people have enough capital readily available to buy a vehicle outright.

The first step for many people in the car-buying process is taking out a car loan.

A car loan is essentially a personal loan that is used to purchase a car.

Understanding what a car loan is and how it works can prevent you from borrowing from the wrong lender or taking on too much debt.

How Do Car Loans Work?

how do car loans workWhen you take out a car loan from a bank or dealership, you receive the money in a lump sum. In return, the lender requires the borrower to make payments on the loan, plus interest. The borrower will make incremented payments until the entire amount is paid back.

The amount borrowed, the loan term, the down payment, and the auto loan interest rate all contribute to how much your monthly payments will be.

Because a car loan is a personal loan, this means that it is often unsecured. Unsecured loans do not have any collateral backing them up, meaning that the lender is judging your trustworthiness to make full, timely payments on your loan through measures like your credit score. However, this does not mean that you get off scot-free if you don’t make your payments. Failure to make your monthly payments will result in repossession of the vehicle.

While this may sound scary, you will be fine if you make your payments on time. Many lenders or dealerships even offer autopay options if you are worried about forgetting a payment. Some banks even offer discounts if you set up autopay.

Important Components of Auto Loans to Consider

Car loans can be broken down into five simple parts. Most loans will include the following building blocks:


Loan payments are comprised of two parts: the principal plus the interest. The principal, or loan cost, is the amount that is negotiated for the actual vehicle, and it’s the amount that the lender is paying to cover the cost of your car.

Interest Rate

The interest rate is the percentage of the principal that is charged by the lender for the amount of money borrowed. This is how the lender makes money off of your loan. The interest rate is typically expressed as the annual percentage rate (APR). It is vital to find an auto loan with the best interest rates to help save money.

Down Payment

The down payment is the amount that you will pay upfront when you purchase the vehicle. It is typically a percentage of the principal. This is not a legal requirement, but the lender will almost always require this as a way to know that you are serious about your purchase and have some form of capital to back it up.

Loan Term

The loan term is the amount of time it will take you to repay your loan. Car loans typically range anywhere from three to six years. If you choose to make your payments over a longer loan term, the interest rate will increase as a result. Even though a lower monthly payment sounds good, you could end up spending more over the lifetime of the loan.

Terms and Conditions

The terms and conditions refer to anything else that the borrower insists upon in order to finalize the loan. These can include insurance, registration, or maintenance requirements. A lender may also clarify conditions regarding loan default and repossession. It’s always important to understand the terms and conditions of your loan thoroughly before signing.

If a loan is listed as conditional or contingent, this means that the terms of the loan are not final when you drive off the lot. This is a red flag, and borrowers are generally advised to avoid loans like these.

Auto Loans from a Bank vs. Dealership

If you’ve started looking into getting a car loan, you may notice that there are a lot of places to get them. People tend to get stuck on whether to get their loan from a car dealership or a bank.

Direct lenders (banks) or indirect lenders (dealerships) offer various benefits and drawbacks. Understanding what each institution has at stake can help you make the best choice when it comes time to choosing a lender.

Direct Lenders

Many people choose to get their loan directly through a financial institution, such as a bank or credit union, which often appeals to people because you avoid a go-between and can often secure better rates. Depending on the institution, you can apply either at the brick-and-mortar location or online. The lender will give you a letter of approval that you can take with you to the dealership to indicate that you’ve been preapproved for a loan.

Indirect Lenders

The other option is to get a loan through the auto dealership, allowing for a one-stop-shop experience when buying a car. You can often complete the entire process in a single day, which can help you avoid driving all over town. The dealership will offer rates from several lenders, giving you a choice of where to take out a loan.

Auto dealerships may also offer special deals to incentivize buyers to lend through them. However, the dealer is the middleman, meaning that there are fees charged for arranging the loan for you. These fees can make dealership loans more expensive than financial institutions.

No matter where you take out your loan, the institution that owns your car loan will become the lienholder, meaning that if you default on your loan payments, they are the ones that will repossess your car. Sometimes, your initial lienholder will sell your loan to another party. You can find out who your current lienholder is by contacting the DMV to get your car’s title, which will tell you who owns the vehicle.

How To Get A Car Loan

Once you’ve decided to take out a loan to buy a car, there are several steps to secure the loan.

The following steps will help you find the right loan for you and your needs.

1. Determine A Budget

You’ve heard it before; live within your budget. If you commit to a loan that is outside of your means, you will either scramble each month to come up with payments or end up defaulting on your loan. This decision can result in repossession and hurt your credit score. Before you even begin to look for a car, determine what a reasonable monthly payment would be. Always find a car that fits into your budget, not adjusting your budget to fit a specific car.

2. Check Your Credit Score

A lender is going to determine how likely you are to make your payments based on your credit score. Your credit score will impact the type of interest rates you qualify for or if a lender wants to lend to you at all. Make sure you know where you stand concerning your credit before setting out to find a lender.

3. Compare Loans

Finding a good loan deal is essential before shopping for a car. The name of the game when shopping for auto loans is to get the lowest interest rate you can, which will help make your monthly payments more manageable. You will also want to consider what kinds of terms and conditions the lender requires. They may offer low-interest rates, but it may also come with some hefty terms and conditions.

4. Get Approved For A Loan

Make sure you understand what you realistically qualify for before you begin shopping to help keep your expectations in check. There’s nothing worse than finding the right car and realizing you don’t qualify for the loan.

5. Start Car Shopping!

Once you establish your budget, your credit score, and pre-approved loan options, it’s time to shop for your new vehicle. When you find the right car, let the lender know the year, make, model and Vehicle Identification Number (VIN.) You will also need to purchase car insurance as many dealerships will not let you drive off the lot without it.

Can I Get A Car Loan with Bad Credit?

Nothing can sour the idea of getting a new car quite like bad credit. Even if your credit is less than perfect, there are ways to secure a loan with bad credit.


A co-signer is someone willing to put their name and credit on the line for your purchase, meaning that if you default on the loan, you will be affecting their credit score too. Keep that in mind, when you decide your budget.

Peer-to-peer Loans

Not interested in asking someone to co-sign the loan with you? Peer-to-peer (P2P) auto lenders may be able to help. P2P loan sites run your credit score and market you to potential lenders. If your credit score is low or nonexistent, you will be listed as a high risk. If a lender decides to take a chance on you, you will have a higher interest rate than you would through a cosigner. It is a way to get a loan no matter what your credit score is.

Should I Pay Off My Car Loan Early?

Come into a bit of extra cash and want to pay off your loan early? It may be more complicated than you think.

While the idea of paying off the remainder of your principal sounds like a no-brainer, there may be language in the terms and conditions of your loan that prevent you from an early pay-off. Remember, financial institutions make money off of the interest of your loan. If you try to pay it early, you may be slapped with a prepayment penalty fee, or they may not let you pay early at all.

Despite this, your state may have laws that allow you to make principal-only car payments early. If your lender tries to prevent you from making principal-only payments, but the state law allows it, cite the law and require that they make an exception.

It’s also a good idea to consider putting the extra payment amounts into a savings account. When you have saved enough, pay off the remainder of the loan all at once.

What Happens If I Pay Off My Auto Loan Early?

If you still want to pay off your car loan early, here are some things to consider:

You May Have to Pay the Remainder of the Interest Anyway

Car loans work off of simple interest, meaning that interest is calculated as a percentage of the principal, so your monthly interest payments remain fixed over the course of the loan.

Sometimes, however, a lender will use pre-calculated interest. If you try to make early payments, the lender may put your extra cash towards paying off the pre-calculated interest first rather than the principal. If this happens, consider refinancing the loan with a company that uses true simple interest rather than precalculated interest.

Your Credit Could Suffer

When you pay off loans early, you risk hurting your credit score.

On-time payments play a significant role in determining your credit score. When you make payments on time, it tells other lenders that you are a responsible borrower. By paying off your loan early, you miss out on the opportunity to improve your credit score even more.

Credit reporting agencies also take into account the “credit mix.” If you have several types of credit open at once and diligently make your payments, such as a mortgage and a credit card account, it shows that you can handle your credit. Eliminating a credit account removes a line of credit from that mix and may cause your score to drop.

Is a Car Loan a Good Idea?

Buying a car is not an investment because they are a depreciating asset. However, they are the primary mode of transportation for many people, especially people who do not have public transportation readily available.

If you are looking to buy a car, be sure to secure a loan that fits within your budget before purchasing your vehicle. Defaulting on a loan and having your vehicle repossessed can damage your credit score and make it harder to buy another car in the future.

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