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March 8, 2024

How Does a Car Loan Work? 2024 Guide

Need to know how a car loan works in 2024? Learn more about applying for a car loan, considerations and requirements, and more in this guide.

Woman with her car
Written by

Sarah T.

Buying a car is a big deal because it costs a lot of money. In fact, it’s one of the most expensive purchases you will make during your lifetime. Imagine this: the price tag on a new car can be over $45,000, and even a used one can set you back more than $26,000. That's a lot of cash! But there's more to the story than just the sticker price. Most folks can't pay all that money upfront, so they get a car loan to help spread out the cost. This way, buying a car becomes more manageable, and you don't have to empty your savings account all at once.

However, when you take out a loan, you also have to pay interest, which means the car costs more than its price tag. In fact, the interest rate on your loan is a big deal—it's usually the second biggest expense when buying a car. But here's a silver lining: if you snag a good interest rate, you could save a bunch of money in the long run.

Since there are so many different types of car loan options out there, it can be tricky to figure out which one is best for you. That's where this guide comes in. We will break down what car loans are, how they work, and how to pick the right one for you in 2024. Let's dive in and explore the types of car loans together so you can hit the road without breaking the bank.

Man with his car and its auto loan

What is a car loan?

An auto loan is a way for you to borrow money to buy a car. Instead of paying the full price of the vehicle upfront in cash, you can take out a loan, which allows you to spread the cost over time. This loan is called a "secured loan" because it uses the car you're buying as collateral. This means if you don't keep up with your loan payments, the lender could take the car back.

You can get auto loans from various places like banks, credit unions, and online lenders. When you buy a car using a loan, the seller gets paid the full amount immediately by the lender, and then you pay back the lender in monthly installments over a certain period.

Here's a quick rundown of how car loans work and some key terms you should know:

  • Interest rate: This is the extra percentage you pay to the lender on top of what you borrowed. Initially, a big portion of your monthly payment goes towards paying off this interest. Although your total payment amount stays the same throughout the loan term, if it's a fixed-rate loan, the portion that goes towards the principal (the original loan amount) increases over time.
  • Down payment: This is an upfront payment you make on the car's price. It reduces the total amount you need to borrow. A larger down payment could help you get better loan terms, like a lower interest rate.
  • Repayment period (Loan term): This is the length of time you have to pay back the loan, which can range from 36 to 96 months (or three to eight years). Shorter loans often have higher monthly payments but lower overall interest costs.
  • APR (Annual Percentage Rate): The APR reflects the yearly total cost of borrowing, including the interest rate and any lender fees, as a percentage. It gives you a comprehensive look at how much the loan will cost you annually and is crucial for comparing different loans.
  • Collateral: The vehicle is collateral since auto loans are secured by the car you're buying. This setup tends to result in lower interest rates compared to unsecured loans. However, it also means that the lender could repossess your car if you can't make payments.
  • Prepayment penalty: Some loans come with a fee if you pay off your loan early. Checking for prepayment penalties before you sign your loan agreement is important.

What are the different types of car loans?

When it comes to car loans, there's no one-size-fits-all. Different types of loans cater to different financial situations, credit histories, and buyer needs. Understanding the variations can help you find the right fit for your situation. Here's a breakdown of some common types of car loans:

Fixed-rate loans

Fixed-rate loans are the most straightforward type of auto loan. The interest rate you agree to when you sign the loan paperwork stays the same throughout the life of the loan. This predictability makes budgeting easier, as your monthly payment amount won't change.

Adjustable-rate loans

Adjustable-rate loans have interest rates that can change over time, based on market conditions. While these loans might offer lower interest rates initially, they carry the risk of rates—and consequently, your monthly payments—increasing in the future.

Cosigner loans

A cosigner loan might be an option for those with poor or no credit history. This type of loan allows someone else, like a family member with good credit, to sign the loan with you. Their creditworthiness can help you secure a loan you might not have qualified for on your own, potentially with better terms.

Refinancing loans

Refinancing is an option for individuals who already have a car loan. If interest rates have dropped or your credit situation has improved since you got your original loan, refinancing can let you negotiate new terms for your remaining balance. This might mean a lower interest rate, a different loan term, or both.

Interest rates and APRs

When discussing car loans, it's important to talk about interest rates and Annual Percentage Rates (APRs). APRs are often the rate most advertised by lenders because they give a fuller picture of what you'll pay annually. This rate includes the interest rate plus any additional costs or fees associated with the loan.

Currently, APRs can range significantly—anywhere from 5.07% to 21.38%—depending on factors like your credit score and the type of auto loan you're applying for. The average car loan interest rate now hovers around 9.00%. Remember, a lower APR means you're paying less over the life of your loan, so it's crucial to shop around and compare rates from different lenders.

Piggy bank on car representing car loans

Choosing the right type of car loan 

Choosing the right type of car loan is crucial for managing your finances wisely when buying a vehicle. Here are some key considerations to keep in mind during your search. While we've touched on some of these aspects above, a focused look can help you weigh your options more effectively:

Credit score

Your credit score significantly influences the interest rates you'll be offered. A higher score can unlock lower rates, saving you money over the life of your loan. It's a good idea to check your credit score before applying to know where you stand.

Down payment/Available cash

The size of your down payment can affect your loan's interest rate and monthly payments. A larger down payment reduces the amount you need to borrow, potentially qualifying you for better loan terms. Consider how much cash you can comfortably put down without straining your finances.

Cosigner options

If your credit history isn't strong or you're a first-time buyer, having a cosigner with a solid credit score can improve your loan approval chances and terms. This shared responsibility means the cosigner is equally liable for the loan repayment, so choose someone you trust.

Repayment period

The length of your loan term impacts your monthly payments and the total interest paid. Shorter terms mean higher monthly payments but you’ll pay less in interest over time. Conversely, longer terms lower your monthly payments but increase the total interest cost. Consider what you can afford monthly while minimizing total interest.

Used vs. new

Loan conditions often differ between new and used cars. Loans for new cars typically have lower interest rates, but the vehicle's faster depreciation means you might owe more than it's worth sooner. Used car loans can come with higher rates, but buying a used vehicle often means a lower overall cost, even if the loan APR is higher.

Making the right choice

In wrapping up our guide on "how does a car loan work," we've covered the essentials: understanding what a car loan is, exploring the different types available, and highlighting key considerations like credit score, down payment, cosigner options, repayment periods, and the choice between new and used cars. Choosing the right car loan is a significant decision that hinges on finding the option that aligns with your financial situation and vehicle needs.

Remember, every detail counts when it comes to financing your car. Doing your homework and consulting with financial professionals can help you make a decision that fits your budget and preferences. Whether you're eyeing a brand-new ride or considering refinancing options for your current vehicle, selecting a loan that serves your interests is super important.

Ready to take the next step? Get started today by exploring your refinancing options with us. Click here for a free quote.