Mastering Car Loans:
How Do They Really Work? [2023 Updated]

What is a car loan?

A car loan is a type of financing arrangement that allows an individual to purchase a new or used vehicle by borrowing money from a lender, such as a bank, credit union, or auto financing company.

A car loan requires the borrower to pay off the borrowed amount together with interest and fees over a certain period, which is called the loan term, usually between 36 and 72 months.

The car is used as collateral for the loan, meaning that the lender retains the ownership until the final payment has been made. Therefore, it’s important to make the required payment on time or at risk of having the purchased vehicle repossessed by the lender.

How do car loans work?

Car loans assist borrowers in financing the purchase of the vehicle they desire, with borrowings that must be paid off in fixed installments with regular monthly payments over the loan duration.

To get a car loan, borrowers can get help from lenders like banks, dealerships, and online lenders. After submitting a loan application to the lender and getting approved, the money will be delivered to make the purchase.

The cost of the loan is determined by several factors, including the loan amount, the interest rate, and the loan term. The borrower's credit history and financial situation will also play a role in determining the terms of the loan.

To better understand how car loans work, let's consider an example:

• Loan amount: $25,000
• Interest rate: 3.5%
• Loan term: 60 months (5 years)

Using an online car loan calculator, the monthly payment for this loan would be approximately $455. The total interest paid over the life of the loan would be around $2,300, bringing the total cost of the loan to $27,300.

In this example, the borrower has to pay $455 per month for 5 years to make the final payment. At the end of the loan term, the borrower needs to pay back the original loan amount ($25,000) plus the interest accrued ($2,300), resulting in a total cost of $27,300 for the loan.

What Factors Affect the Monthly Payment on Your Car Loan?

There are several factors that influence the monthly payment on your car loan. The main factors include the loan amount, the annual percentage rate (APR), and the loan term.

The Loan Amount

The loan amount means the amount of money you have to borrow from the lender to make the purchase, excluding interest and fees. Assuming the repayment period is fixed and predetermined, a larger loan amount will lead to higher monthly payments. Be careful to increase the loan amount you take, as it imposes higher payback burdens every month.

Example: Suppose you want to buy a car priced at $30,000. If you make a down payment of $5,000, you would need to borrow $25,000. If you borrow $20,000 instead, your monthly payment will be lower because you're borrowing less money.

The Annual Percentage Rate (APR)

The annual percentage rate (APR) refers to the actual yearly cost charged by the lender, always represented as a percentage. It covers not only the interest rate but other car loan-related fees, such as mortgage insurance, origination fees, transaction fees, and some closing costs.

So evaluate carefully when you look at the rate offers, as a higher APR indicates that more costs would be incurred from the loan per year, leading to higher monthly payments.

Example: If you have a $25,000 loan with an APR of 4% and a 5-year term, your monthly payment would be about $460. However, if the APR were 6%, your monthly payment would increase to around $483.

The Loan Term

The loan term is the length of time you have to repay the loan, typically expressed in months. A longer loan term will result in lower monthly payments since you'll have more time to repay the loan. However, this also means you'll pay more interest over the life of the loan.

Example: If you have a $25,000 loan with a 4% APR and a 5-year term, your monthly payment would be about $460. If you extend the loan term to 6 years, your monthly payment will decrease to around $391, but you will pay an additional $552 interest overall.

How a Lower Monthly Payment Can Cost You More

It may sound alluring to get a car loan with lower monthly payments since it can temporarily ease your liability burden and increase your cash flow every month.

Yet it's important to realize that reduced monthly payments won’t necessarily result in cost savings. In fact, it's frequently the case that more costs are incurred from the loan when you select a lower installment solution.

Typically, there are two ways to reduce your monthly payment, by extending the loan term or bargaining for a lower interest rate with the lender.

It’s true that your monthly payment will be lower if you take out a loan for a longer period of time, but it comes at the price of more interest and fees being charged. In other words, you will wind up spending more instead of saving money in the long term.

Example: Let's consider a $25,000 car loan with a 4% APR.

5-year term (60 months):

• Monthly payment: $460
• Total payment: $460 x 60 months = $27,600
• Total interest paid: $27,600 - $25,000 (loan amount) = $2,600

6-year term (72 months):

• Monthly payment: $391
• Total payment: $391 x 72 months = $28,152
• Total interest paid: $28,152 - $25,000 (loan amount) = $3,152

In this example, the borrower would incur $552 more in interest costs over the 6-year period than they would have throughout the 5-year term, despite making a smaller monthly payment of $391.

Therefore, when you intend to take out a longer loan term, be mindful to balance the advantages of lower monthly payments against the cost of money and time.

Where to Get a Car Loan

When looking for a car loan, it's essential to explore all your options to find the best terms and interest rates. There are two primary sources of car loans: direct lending and dealership financing. Understanding the advantages and disadvantages of each will help you make an informed decision.

Direct Lending

Getting a car loan through direct lending refers to borrowing from financial institutions such as banks, credit unions, or online lenders directly.

Before going to the dealership to make the purchase, you need to submit a loan application to the lender and wait for the approval. Once your loan request has been approved, you will be provided with a loan agreement that includes information on the total amount they can offer, the interest rate, and other terms and conditions.

Advantages of direct lending:

• Shopping around: You may compare loan terms and interest rates from various lenders to be sure you're getting the best available deal.

• Prequalification: Being pre-qualified means you can be provided with a preview of the potential interest rates and terms you’re getting. Many lenders offer this option to help you compare before the final application, with no negative impact on your credit.

• Credit history: A bank or credit union may be more willing to offer you advantageous terms and conditions if you have previously chosen their service, which provides a visible credit history.

Disadvantages of direct lending:

• Time-consuming: Shopping for a car loan can be time-consuming, as you'll need to contact multiple lenders and compare their offers.

• Approval process: Some lenders may have stricter approval requirements, making it more challenging to obtain a loan if you have less-than-perfect credit.

Dealership Financing

Dealership financing refers to using the dealership where you're buying your car as a loan agency to secure a car loan from other lenders.

In this situation, the dealership will seek out a loan on your behalf by negotiating with a number of banks or other financial institutions, which can help save you energy and time compared to taking out a loan yourself. However, it often comes with higher interest rates as the dealer has to gain profit for its service.

Advantages of dealership financing:

• Convenience: Dealership financing can be more convenient, as you can handle both the purchase and financing of your vehicle in one place.

• Promotional offers: Dealerships often have promotional financing offers, such as low-interest rates or cashback incentives, which can make financing through them more attractive.

• Easier approval: Dealerships may have more flexibility when it comes to approving loans, especially for buyers with less-than-perfect credit.

Disadvantages of dealership financing:

• Limited options: As dealerships usually only partner with a specific group of financial institutions, you may have fewer alternatives for lenders and loan terms when taking out the dealership financing.

• Lengthy negotiation: Some borrowers may find it stressful to negotiate the dealership terms, as dealership financing often entails more agreement discussions than direct financing, which may cost more time and energy.

• Higher interest rates: Dealerships work as an agency on your behalf to bring convenience, and the service can cost you more with a higher interest rate. Profit is charged by dealers, which means you might pay a higher rate than if you had gone to a direct lender.

Requirements for Applying for a Car Loan

When applying for a car loan, it is crucial to be aware of the specific requirements set forth by the lender.

These requirements may vary, but there are some common criteria that many lenders consider when assessing a borrower's eligibility. By meeting these requirements, you can increase your chances of securing a car loan with favorable terms.

Credit Score

To get a car loan with low-interest rates, you must have a good credit score (670–739). Credit scores are used by lenders to assess a borrower's creditworthiness and the likelihood of defaulting on loan payments.

In most cases, high credit scores can be a big indicator of a strong ability to manage your debt and make your full payment on time, showing a responsible and prompt image to the lender.

Employment and Income Stability

Lenders prefer borrowers with a stable employment history and consistent income. This demonstrates that you have a reliable source of funds to make your monthly loan payments.

A recent pay stub, tax return, or bank statement could be requested as proof of work. Additionally, to further guarantee you can handle the loan installments without effort, certain lenders may also have minimum income criteria. Be mindful to check the criteria and make sure you meet the required standards.

Debt-to-Income Ratio

Your debt-to-income (DTI) ratio measures your monthly debt obligations compared to your gross monthly income.

This proportion is used by lenders to determine your ability for budgeting and debt repayment; the lower the number, the better. So, a low DTI ratio serves as convincing evidence that you earn enough money to pay off both your current loans and the upcoming installments. Most lenders often view a DTI ratio of 43% or less as acceptable.

Down Payment

A down payment is an upfront amount you pay towards purchasing a vehicle. A larger down payment reduces the amount you need to borrow, which can result in lower monthly payments and a lower interest rate.

Lenders may have specific down payment requirements, so it's essential to be prepared to make an adequate down payment based on the lender's guidelines.

Vehicle Age and Value

Lenders may consider factors like the age and value of a car to decide whether to approve it or not.

Due to the high likelihood of mechanical issues or a potential value decline, some lenders may refuse to finance older or high-mileage vehicles.

Also, there are other factors that might affect the potential risk, such as the type, model and trim of the car. So, be mindful to make sure the car of your choosing fulfills the lender's requirements, as the loan amount may also be constrained by the car's worth.

Proof of Insurance

Before approving your car loan, lenders typically require proof of insurance coverage for the vehicle. Full coverage insurance, including comprehensive and collision coverage, is usually necessary to protect the lender's investment in the event of an accident, theft, or damage to the vehicle.

Co-signer (if applicable)

If you choose co-signer financing, the lender will consider both your credit score and financial support as both of you take full responsibility for the loan payment.

Finding a trustworthy and responsible co-signer with good credit and a steady income may improve your approval rate and decrease the interest rate you are getting, especially when you have a limited credit history, imperfect credit, or no credit at all.

Can someone else take over your car loan?

There could be times when some things go wrong and you find it difficult to carry on the car repayment, and you might be considering whether another person can take over the liability.

Yes, it is possible for a third party to take over your car loan. This could happen through loan assumption, refinancing, or by selling the vehicle and utilizing the proceeds to pay off the current balance. But these options come with certain limitations, as the take-over procedure is restricted by the lender's policy and the new borrower's eligibility.

Though completing the transfer procedures can be a cumbersome task, it provides available options to ease the borrower’s loan burden.

Loan Assumption

In a loan assumption, a different party takes over both the terms and the remaining balance of your car loan, then becomes the new borrower.

However, not all lenders allow loan assumptions, and the new borrower must meet the lender's credit and income requirements to qualify for the loan. If the lender approves the assumption, the original borrower is released from their obligation, and the new borrower takes full responsibility for the loan.

Refinancing

Another option is for the person interested in taking over the car loan to refinance the car loan in their name.

Refinancing requires a second loan that the new borrower has secured to pay down the old one. The new borrower subsequently takes over ownership of the debt as well as the responsibility of making monthly payments. Similar to loan assumption, the new borrower must also satisfy the lender's requirements of income and credit to be eligible for refinancing.

Additionally, refinancing can be used to get better interest rates and more favorable terms, especially when your credit has recently improved or you want to shorten or extend the loan term.

Selling the Vehicle

If loan assumption or refinancing is not possible, another option is to sell the vehicle to the interested party. The proceeds from the sale can be used to pay off the existing loan, and the new owner can obtain their own financing to purchase the vehicle.

This method requires coordinating the sale and loan payoff to ensure that the title can be transferred to the new owner free of any liens.

It's not recommended to just enable someone else to make payments on your behalf without properly transferring the debt. Any late or missed payments could have a negative effect on the credit score of the original borrower, who is still legally liable for the loan.

How Can a Car Loan Affect Your Car Insurance?

When you finance a car with a loan, it's essential to understand how it can impact your car insurance. A car loan can affect the type of coverage you need, the cost of your insurance premiums, and your overall financial protection in case of an accident or damage to your vehicle.

Required Insurance Coverage

When you take out a car loan, the lender typically demands your insurance policy be covered by comprehensive and collision terms. As the lender retains the ownership of the vehicle until the final payment is made, this rule safeguards their financial interest.

• Comprehensive Coverage: This type of insurance protects your vehicle against non-collision damages, such as theft, vandalism, fire, or natural disasters.

• Collision Coverage: Collision coverage helps pay for damages to your vehicle resulting from a collision with another vehicle or object, regardless of fault.

These coverage types ensure the lender can recoup their investment if the car is damaged, stolen, or totaled. If you own the car outright, you can choose to carry only liability insurance, which is typically less expensive.

Insurance Premiums

Your insurance premiums may increase if you have a car loan. In this case, your premiums are generally higher than for liability-only coverage since you must maintain comprehensive and collision coverage.

Additionally, your insurance premiums may also be affected by other auto-related factors, such as the type and age of the car, your driving habits, and demographic features. For example, repair expenses spent on newer, more expensive cars are typically greater, which can result in higher insurance premiums.

GAP Insurance

GAP insurance, or Guaranteed Asset Protection insurance, is an optional coverage that you may want to consider when financing a car.

If your car is wrecked or stolen, GAP insurance can help fill the gap between the current market value of your car and the remaining debt on your loan.

When your car's value is declining faster than you are repaying it, it could lead to a "gap" between the upcoming repayments and what the insurance company will pay out, and having GAP coverage can make up for your loss in this situation.

For example, let's say you financed a car for $30,000, and after two years, the remaining loan balance is $20,000.

If the car is totaled in an accident, and the insurance company determines the current market value of the car is only $15,000, you would still owe the lender $5,000. GAP insurance would cover this difference, protecting you from having to pay the remaining balance out of pocket.

Tips for Reducing Insurance Costs

While car loans can affect your insurance costs, there are ways to mitigate the impact and save money on your premiums:

1. Shop around: You may compare different coverage options, rates, and terms from various insurance companies to be sure you're getting the best available deal.

2. Bundle policy: Most insurance companies offer additional discounts if you bundle your auto insurance with other policies, such as homeowners or renters’ insurance.

3. Deductible amount: Your premiums may be reduced by selecting a higher deductible, but a higher out-of-pocket payment could be incurred in case of a claim.

4. Driving history: If you have a spotless driving record free of tickets or accidents, it can serve as proof of a responsible and prudent driver behind the wheel, which leads to lower premiums.

5. Discounts: You can seek discount policies from insurance providers that suit your personal situation, based on some criteria like good grades, completion of defensive driving courses, or low annual mileage.

In conclusion, having a car loan can impact your car insurance by requiring additional coverage, potentially increasing your premiums, and influencing your overall financial protection. Understanding the relationship between your car loan and insurance will help you make informed decisions when selecting coverage options and finding ways to save on your insurance costs.

How to reduce the cost of your car loan?

1. Design a Payment Plan for Yourself

Before you apply for a car loan, you should carefully estimate your monthly budget for monthly installments, creating your repayment schedule beforehand. Make sure to take all the potential expenditures into account, such as those related to maintenance, insurance, and other auto-related expenses.

If you have a clear awareness of your financial status, it will be easier for you to select a loan that suits your budget and reduce the risk of incurring revolving debt.

2. Shop Around

It’s not recommended to rush into any quick decision. Be patient to spend some more time investigating various financial institutions across banks, credit unions, and online lenders.

You may identify the most affordable rates and terms by comparing loan offers from a variety of sources, which could end up saving you lots of money in the long term.

3. Improve Your Credit Score

A higher credit score can lead to better interest rates on your car loan. If possible, take steps to improve your credit score before applying for a loan. Pay your bills on time, reduce your debt, and check your credit report for errors to ensure your credit score accurately reflects your credit history.

4. Make a Larger Down Payment

Offering a larger down payment can help relieve your monthly payment stress and increase the chance of getting a lower interest rate. Although it takes time and effort to accumulate enough cash for a large down payment, it brings substantial benefits in the long run.

5. Choose a Shorter Loan Term

Although a longer loan term often results in lower monthly payments, it also means you'll pay more in interest over the life of the loan. Opting for a shorter loan term can save you money in the long run, even if your monthly payments are higher.

6. Make extra or early payments

If there is no penalty when you make the final payment earlier than scheduled, making extra or early payments can speed up loan repayment and reduce interest costs. The interest incurred over the loan term can be significantly decreased even with an additional payment each year or a slightly larger payment each month.

7. Refinance Your Loan

If your credit score has improved or interest rates have dropped since you took out your car loan, you may be able to refinance the loan at a lower interest rate. Refinancing can potentially reduce your monthly payments and save you money on interest over the remaining loan term.

8. Avoid Expensive Add-ons

After completing your purchase, the dealer may present some premium services to you, such as an extended warranty, paint protection, or fabric protection. Think carefully about whether you need these with their value versus cost. If you don't require the extras, declining them can help you save money and reduce the loan amount.

Key Terms to Know About Car Loans

• Annual Percentage Rate (APR)

The annual percentage rate (APR) reflects the annual borrowing costs of a loan, always represented as a percentage. It covers the interest plus other auto-related fees, allowing you to compare the actual cost of a certain car loan.

• Down Payment

The down payment is the initial amount you pay upfront for a car purchase. It reduces the amount you need to finance through a car loan. A larger down payment typically results in lower monthly payments and reduced interest costs.

• Loan Term

The loan term refers to the length of time you have to repay the car loan, usually expressed in months (e.g., 36, 48, or 60 months). A longer loan term usually results in lower monthly payments but higher total interest costs.

• Monthly Payment

The monthly payment is the total amount you pay every month on your car loan, including principal and interest charged on top of the principal. How much you pay every month generally depends on the loan amount, interest rate, and loan term.

• Principal

The principal refers to the original amount borrowed from the lender, not including any interest or additional fees. The total principal is divided into equal monthly principal payments, and it always stands for the amount that hasn’t been paid, so it reduces every time you make a payment.

• Total Car Cost

The total car cost includes the purchase price of the car, interest paid on the car loan, and any additional fees or charges associated with the purchase, such as taxes, registration, and dealer fees.

• Interest Rate

The interest rate is the percentage of the car loan principal the lender charges as interest. It's the cost of borrowing money, and a lower interest rate typically results in lower overall loan costs.

• Amortization

Amortization is the process of gradually paying off a loan over a set period of time through regular payments.

In the context of a car loan, amortization involves making monthly payments that include both principal and interest components. Over the loan term, the portion of each payment allocated to interest decreases while the portion applied to the principal balance increases.

As a result of amortization, your loan balance gradually reduces over time until it reaches zero, at which point the loan is fully repaid.

• Taxes and Fees

Taxes and fees, such as sales tax, registration fees, and dealer paperwork fees, are extra expenses related to buying a vehicle that are frequently added to the overall financing amount.

• Car Financing

Car financing refers to borrowing money to purchase a vehicle through a loan from a bank, credit union, or other financial institution.

• Loan-to-Value Ratio (LTV)

The loan-to-value ratio is the amount of the loan compared to the value of the vehicle. A lower LTV indicates that you're borrowing less relative to the car's value, which can result in more favorable loan terms.

• Co-signer

A co-signer is a second person who agrees to take full responsibility for a loan if the original borrower defaults on it. It decreases the risk of lenders, as a co-signer acts as a guarantor to provide double insurance for their funds.

So, finding Co-signers with good credit and a steady income can make loans more accessible to borrowers, even with imperfect credit or limited credit history.

FAQs

What is a lienholder on a car?

The term "lienholder" refers to a person or organization that has a financial stake in a vehicle as they provided the funds used to buy it, such as a bank, credit union, or other financial institution. The lienholder on a car loan is essentially the lender, who claims ownership of the vehicle up until the final payment has been made.

The lienholder is listed on the vehicle's title, and their interest in the car serves as collateral for the loan. If the borrower defaults on the loan or fails to make the required payments, the lienholder has the legal right to repossess the car and sell it to recover their outstanding loan balance.

Once the borrower has paid off the loan, the lienholder releases their claim on the vehicle, and the borrower becomes the sole owner of the car with a clear title.

Is it better to get a car loan from a dealership or from your bank?

There is no one-size-fits-all answer to this question, as the best choice depends on your individual circumstances.

You can get the best interest rate and loan terms based on your personal situation by shopping around and comparing offers from banks and dealerships.

Additionally, while dealerships could provide higher promotional financing rates or manufacturer incentives, it’s worth noticing that banks or credit unions may offer more competitive rates if you are a current client.

Does an auto loan hurt your credit?

An auto loan can initially cause a slight dip in your credit score due to the hard inquiry on your credit report when you apply for the loan. However, making timely payments on your auto loan can positively impact your credit history and ultimately improve your credit score over time. Consistently late or missed payments will harm your credit score.

Are loans for pre-owned cars different from new car loans, and if so, how?

Loans for pre-owned cars can differ from new car loans in several ways:

1. Interest Rates: The interest rate on new cars is typically lower than it’s on used cars with higher mileage. This is because lenders may view used cars as a greater risk due to the depreciation of the vehicle and the potentially increasing costs for repair.

2. Loan Terms: The loan terms offered for pre-owned cars may be shorter, as used vehicles are generally older and have depreciated in value.

3. Requirements: Many lenders impose limitations for used cars, such as maximum ages or mileage caps, which may have an impact on loan eligibility.

Despite these differences, the loan application process is similar for new and pre-owned cars. It's crucial to compare loan offers and choose the one that best suits your needs and financial situation.

Summary

Car loans help buyers finance vehicles by dividing costs into manageable monthly payments. By considering loan amount, APR, and loan term, borrowers can understand their monthly obligations.

It's essential to evaluate car loan sources, meet eligibility criteria, and implement cost-saving strategies. Being knowledgeable about car loan terms and common questions aids in making well-informed decisions and securing optimal loan conditions.