Rateworks auto loan refinance
July 5, 2022

How do car loans work?

Have you ever found yourself wondering, how does a loan work for a car? Is it different than a personal loan? Check out this blog for more on what it means to borrow money for a car loan.

Understanding how an auto loan works is important before you enter into any type of car financing agreement.
Written by

Matthew Oliver

How do car loans work?

Short Answer: A car loan is money that is lent to you, to help pay for your car. However, banks or lenders do not lend money for free, they include a fee on top of what you are borrowing, this is called interest.

A car loan is money that is lent to you, to help pay for your car

Let's break down some of the key factors of car financing

There are a few different factors that come into play when financing a car. Understanding how all of these different factors impact your auto loan can be a huge help for evaluating not only a car loan but any loan.

Interest rate vs annual percentage rate

We already established interest rate is the cost of borrowing money. Knowing your interest rate is very important because it impacts how much you will be charged in addition to what you are already borrowing. Most car buyers tend to think APR and interest rate are the same thing, but don't get confused, although both of these rates are expressed by percentage, they are in fact different.

APR or Annual Percentage Rate is an all-encompassing number. It is the percentage rate you will be paying annually. APR accounts for the interest rate plus any additional fees that are associated with borrowing money.

When evaluating car financing options you want to make sure you are comparing APR to APR or interest rate to interest rate, otherwise you may not be accounting for all fees.

Loan terms impact your monthly payment too

The loan term is how much time you have to pay back the loan. The most common loan terms are 36 months (three years), 48 months (four years), or 60 months (five years). Some financing companies offer longer loan terms with lower monthly payment options, however extending your loan term might result in paying more interest in the long run.

RateWorks Tip: While shopping for a car loan you may see offers for a 0% annual percentage rate. That may seem very appealing but check the fine print. Sometimes when there is a 0% APR offer you have to agree to a shorter loan term like 24 to 36 months. This means you have to pay the loan back quicker and higher monthly payments.

Don't forget the down payment

So now we have established what it costs to borrow money (APR), and how long you want to borrow money (loan term) but we haven't talked about the down payment amount. Most people will have to pay some type of down payment when financing a car. The down payment is the portion of the loan that the buyer pays out of pocket to finance a car. A substantial down payment will reduce the total amount of money you are financing. On the other hand, it may not be worth it to spread yourself too thin for the sake of a down payment if you would rather have that money in your back pocket for other expenses.

Taxes & fees:

Remember those "other expenses" we were just talking about? State sales taxes and state motor vehicle department fees have to be paid at the time of purchasing a vehicle. You also may have to pay other fees depending on the car dealership.

Credit Score

Your credit score and credit history are very important parts of the car loan process. Your credit will determine which loans you qualify for. Normally, the higher your credit score the lower your interest rate will be. Getting an auto loan with a poor credit score is not impossible but you may have a higher down payment. Unfortunately, you can't improve your credit score overnight so some people consider adding a cosigner to their auto loan to help them get approved for a better loan offer. Learn more about cosigners here!

Financing options

There are multiple lending options out there to consider.

Now that we have broken down some of the important terms to help you understand what car loans include you may be curious about what lending options are out there.

Car Dealerships

Dealership financing may offer fewer interest costs than banks and credit unions. Since most auto dealers offer to finance car purchasers in-house, it can be a good investment. Dealer financing can be the quickest and most efficient solution especially since some car dealerships have partnerships with other financial institutions.

Bank or Credit Union

A good place you could start with is your personal bank or credit union. Credit unions generally have a less expensive operation cost that allows for lower interest rates. Nevertheless, they sometimes require memberships.

Online Financial Institution

Online lenders have become increasingly popular in the past 10 years because they usually offer competitive interest rates. Additionally, comparing loan offers online can be quick and easy.

Be sure to explore all of your options to find the best financing deal but in the event you get a auto loan with unfavorable terms you could always get a free quote to refinance with RateWorks.

Final tips

Auto loans can be intimidating since you are potentially borrowing a large amount of money from a lender. Understanding how an auto loan works is important before you enter into any type of car financing agreement. Learning the terms, knowing your financing options, and becoming familiar with how monthly payments are calculated can help put you on the right path to taking out an auto loan without having to worry too much. At RateWorks we want to be a resource you can trust that eliminates frustration, offers value, and restores your confidence!