What An Auto Loan Is And How It Works

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Prostock-Studio/ Getty Images; Illustration by Austin Courregé/Bankrate

Key takeaways

  • You’ll need an auto loan if you want to buy a vehicle without paying cash upfront.
  • Each month, you’ll pay a fixed amount toward the principal and interest over a set period.
  • You can use dealer financing to purchase a vehicle or arrange auto loan financing through a bank, credit union or online lender.
  • Be sure to compare the APR, loan term and fees before formally applying for an auto loan.

If you want to buy a car, you must first arrange for vehicle financing. An auto loan is simply money you borrow to pay for the vehicle. It includes the vehicle’s purchase price, interest and any applicable fees you choose to finance. Loan specifics vary. Comparing your options and getting the right loan could save you hundreds or thousands of dollars.

What is a car loan?

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 your borrowed money.

If you have a high credit score, you may qualify for a lower interest rate, saving you money. Your credit score helps determine a required down payment and the loan amount you can borrow.

Key terms

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 equals 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.

Monthly payment
The monthly payment is exactly what it sounds like: the amount you pay towards the loan each month. It’s based on the auto loan’s term, amount and interest rate.

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 borrow 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.

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How auto loans work

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

The type 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 financing type. 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

Traditional banks and credit unions offer auto loans. 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 waiting between one business day and a week to get a loan from a bank or credit union.

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.

Online lenders may be more likely to work with borrowers with subpar credit scores. Some even offer favorable bad credit auto loan rates.

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 means you’ll likely have access to better rates. The lender will also factor in 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.

The average new car loan rates for consumers with excellent and very poor credit were 5.61 percent and 14.17 percent, respectively, according to Experian’s Q3 2023 State of the Automotive Finance Market report.

To illustrate, imagine you get a 48-month, $36,000 auto loan. Here’s what you’ll pay each month, along with the total amount you’ll pay in interest over the loan term:

Interest rate 6% 8%
Monthly payment $845 $879
Total borrowing costs $4,582 $6,186

Term

You have a set number of months to repay your auto loan. A typical auto loan term ranges anywhere from 24 to 84 months.

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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, choose a shorter term. Just make sure the payments are well within your budget.

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

Loan term 36 months 60 months
Monthly payment $1,095 $696
Total borrowing costs $3,427 $5,759

Fees

The two main fees you may see are the origination fee and the documentation fee. The origination fee is the amount you pay to secure the loan. The documentation fee covers the lender’s costs for securing your loan.

Compare your monthly and overall costs

You should run the numbers before getting an auto loan so you’ll know what to expect. Use the Bankrate auto loan calculator to compare borrowing costs on auto loans with different rates and terms.

The 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.



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