How Do Car Loans Work: Everything You Need To Know In 2022


Cars have always been expensive. However, recent factors like the COVID-19 pandemic, inflation, and more have caused the prices to skyrocket. Not everyone has that kind of cash lying around. So they’ll need to take out a car loan to cover the expense. 

Unfortunately, car loans aren’t all that simple. There are many things to consider, like the interest, loan terms, and even a good credit score.  If you aren’t careful about taking out a loan, you could lose your own money. We are here to help you understand how car loans work and the best way for you to apply for a car loan. But first, let’s start with understanding what a car loan is.

What Is a Car Loan?

A car or auto loan is a loan you take from a bank or other lenders. The lenders give you the sum you need to buy a new vehicle, and in return, you agree to a repayment period. You will return the loan amount and additional interest during this period. However, before investing in such loans it’s always recommended to do research and understand the basics of car loans to make a sound decision. 

Car Loan Terms You Need to Know

  • Interest Rate: Interest is the money you will pay auto loan lenders for giving you the money. Interest rates determine the percentage of money that you will have to return. The rate depends on the money you borrow, your previous credit history, and the time you need to pay everything back. Lower interest rates are good for you because you have to pay less. Generally, lenders give you reasonable rates if you have a good credit score and select a shorter repayment period.
  • Annual Percentage Rate (APR): APR is the money you’ll give your lender if you borrow money from them. The rate is usually measured as a percentage and includes any fees you must pay along with the interest rate. 
  • Principal: The principal is the money you borrow from your lender and what you must pay back. This amount doesn’t include any interest or loan fees. 
  • Total Cost: Total cost refers to the total amount of your loan. This cost includes fees, interest, and the principal. You’ll pay this amount over the life of the loan.
  • Loan Term: The loan term is the repayment period you set with your lender. You have to return all the money during this set period. Generally, the term can be a year or six years. This term can also be referred to as the life of the loan. 
  • Down Payment: When you buy a car, there is a certain amount that you have to pay upfront. This is called the down payment. After that, you use a loan to pay off whatever is left—the higher your down payment, the lower the loan amount. 
  • Monthly Payment: You pay your lender a small amount during the loan term. This monthly car payment contributes toward the total loan amount. 

How Do Car Loans Work?

Unlike personal loans, that does not require collateral or security and is offered with minimal documentation, car loans work based on a monthly payment agreement between you and your lender. Instead of paying the entire cost of your car at once, you break them into small monthly payments. You make these payments to your lender over a set period.

Your monthly car payments depend on the principal and the interest you must pay. You’re more likely to get better interest rates with positive credit reports. You can probably get a lower monthly payment with a longer loan term. However, you would be paying a lot more in the long run. Hence, lower monthly payments aren’t a good idea.

While making the loan payments, the lender will hold on to the car’s title. The lender can take the car back if you fail to pay the loan. The ability to repossess the car reduces the risk for the lender and grants them some degree of financial protection. 

What Do I Need to Apply for a Loan?

When completing your loan application, you must submit quite a bit of personal information. This information typically includes:

  • Your residential address (past and present)
  • Your employment address
  • Complete income breakdown
  • Past debt
  • Social Security Number

The lender needs to know that you can afford the loan payments. Thus, they will probably verify your income sources to ascertain your financial situation. You will need to tell them about your income from your job or any other business you may have. For that purpose, you can use your pay and tax return slips.

The lender will also look closely at your debt history and your experience with returning the loan amount. They’ll also check your current debts. The lender will probably evaluate that current debt with your income and set the interest rate based on that ratio.

Once the relevant financial institution gets this information, they’ll probably check your credit scores. Moreover, the credit report will help your lender know more about your financial situation. Most lenders consider credit scores higher than 670 to be a good credit score. So, if you want a nice interest rate, you should have a good credit score.

Factors That Affect Your Loan’s Monthly Payment

To choose the best car loan, you must first understand what factors affect your loan. Then you can work to improve your chances of getting the best deal. Several factors can affect your auto loan, and these are: 

  • The Loan Principal 

The amount of your down payment will impact your loan principal, which will, in turn, impact the total loan costs. You won’t have to borrow as much if you can put down a higher down payment. Moreover, you can make a lower monthly payment with a lower interest rate during the loan period. 

Alternatively, you can still get a car if you don’t have any money to put down. However, you will need exceptional credit scores. We don’t recommend getting a car without making a down payment. That’s because your lender may charge you a higher loan fee and interest rate. Additionally, since the total car loan amount will be higher, you may have to pay higher monthly payments or opt for longer loan terms. 

  • Interest Costs

Auto loans work by charging you interest on the loan amount. Your lender will probably charge it as a percentage of the principal. Thus, a high interest will result in a higher monthly payment. For example, a 5% interest rate will cost you more than a 3% interest rate even if your principal amount remains the same.

As a result, your focus should be on looking for ways to reduce the total interest rate on your car loan. You can do that by increasing your credit score. It might be a good idea to check your credit score before applying for car loans. Moreover, you should compare rates while looking at different lenders.

If you have improved your credit score after a loan, you can also consider refinancing the existing loan. Refinancing an existing car loan is like refinancing a mortgage. Your lender may ask you to fulfill a few requirements before they give you a better interest rate. However, we don’t recommend relying on this strategy to get better rates if you haven’t yet availed of a car loan. 

  • Loan Term

The loan term is the time you’ll take to pay everything back. This period will affect the amount of interest and monthly installments for your car loan. Car loans can have terms ranging from a year to multiple years. 

However, a longer term will increase the amount of your interest. Furthermore, the lender will have more time to take this increased interest from you, increasing the total interest paid and, subsequently, the total cost. 

Alternatively, you will have a lower interest rate if you take a shorter term. However, you will have to make higher monthly payments. We recommend choosing a shorter loan term to reduce your overall loan cost. Ideally, your term should be thirty to sixty months long for used and new cars, respectively.

  • Amortization

Amortization is a division in your monthly payment. One portion goes to the loan’s interest while the other pays off the principal. During the early stages of your loan’s term, most of your payments will pay off your interest. Thus, your principal amount will remain essentially unchanged. 

Later, more payments will go toward the principal when you have paid most of the interest. However, the timing depends on how much interest you have to pay. Since your auto loans are amortized, you will be done paying off both your interest and the principal by the time your repayment term is over. 

Is There Any Difference in Leasing and Buying a Car?

Yes, there’s a big difference between leasing or buying a car. You need to understand both concepts to choose what is best for your situation. Buying a car with a loan means you own the car. As soon as you make the last payment, the lender will officially transfer the car’s title to your name.

Leasing is different. When you lease a car, you rent it from a company or individual. You deposit security for the vehicle, and the company will ask you to get GAP insurance. 

The monthly payment you make is just rent for the car. At the end of the leasing period, if you still want the car, you must pay the residual amount to get it. Hence, the lease payments are much lower than rent payments. 

Leasing is best for you if you only need a car for a short time, like a few months. That’s because most loans last for at least a year, and that’s too much money for a car you don’t want to keep. Additionally, the negative equity will make it harder to resell the car and cause you to lose more money. 

To Buy New or Used Cars

Choosing between old and new cars is hard since both have advantages and drawbacks. Before you choose to get a loan, it is best to go through both choices’ pros and cons. 

The loan amounts for used cars tend to be lower because of the lowers costs for used cars. Thus, it’s easier to get auto financing for used cars. Additionally, used car loans tend to have shorter terms. 

Old cars don’t lose their value as fast as new cars. New cars will lose twenty percent of their value in the first year. However, you don’t have to take on this loss since you’re using a used car. Thus, you’re unlikely to become upside down on your loan.  

However, if you want to buy a new car, you’ll probably get better interest rates on them. On the other hand, the repayment terms for new cars tend to be much longer than for used cars. 

The most significant advantage of new cars is that you don’t have to spend additional money on repairs. They’re more reliable, so you can be sure they won’t just break down due to some hidden problem. 

If you choose to buy a used car, be sure to get a certified preowned car. These are used cars that dealerships have inspected for problems. Of course, you’ll have to pay extra for the inspection. However, it beats finding out about a problem later and dishing out a thousand bucks to fix it. 

Where Can You Get the Loan?

There are many financial institutions where you can apply for car loans for your old or new car. You’ll face the major choice between dealer financing and direct financing options like credit unions. Both have their merits, and you should choose an option depending on your situation. 

Direct financing involves you getting a loan from direct lenders. You can get a traditional auto loan through these lenders. A direct lender can refer to online lenders, banks, and credit unions. 

Since you have more options with a private lender, you can look at your loan terms and go for the one with the best rates. You can also use the pre-approval method to see how much APR you’ll get with multiple lenders. Furthermore, if you already have a bank account or credit union, they can offer you much better rates than other financial institutions. 

Dealership financing refers to you getting your loan through the car dealership. The dealership can use registered lenders to get you that loan. This option is more convenient as you can get everything done in one place. 

Furthermore, dealerships tend to be less strict with their lending criteria. Thus, if you have a bad credit score, you might be better off trying to get an in-house loan. The only drawback is that these loans tend to charge more interest. However, dealerships can offer discounts and incentives that may make them worth it. 

Our recommendation is to get a loan through a direct lender. You can take the check you receive to the dealership. That’s because you get lower rates with direct financing. However, if the dealership has a better deal, go for it. Just be sure to read the terms of the contract beforehand.

Frequently Asked Questions

  • What is the average price for a car purchase?

Due to inflation and the recession, car prices are at an all-time high. According to Consumer Reports, a vehicle purchase can cost you $47,000. During the pandemic, the world faced a semiconductor chip shortage that still hasn’t been resolved. Combine that with the post-pandemic increase in car demand, and we get our explanation for the skyrocketing car prices. 

  • What is the difference between a car loan and a personal loan?

Car loans work based on collateral. These are secured loans. If you can’t repay the loans, the lender will take the car and use it to recover the money. Since the lenders are secured for auto loans, they usually charge less interest. Moreover, you can only use auto loans to purchase cars. 

Personal loans are riskier for the lenders. You can get these loans to do almost anything, including buying a new car. Furthermore, the loans aren’t secured since there’s no collateral. These loans tend to have very high interest. 

We recommend choosing to get an auto loan for your car. That’s because they have a lower interest. However, personal loans may be your only option if you can’t qualify for a car loan.

  • What if I can’t get a traditional auto loan?

There are certain circumstances where you can’t get an auto loan. The most probable of these causes is your bad credit history. However, you may still be able to get your car. You will need a co-signer if you can convince someone with a good credit score and income to sign the loan with you. You can get an auto loan. 

The only catch is that they will be responsible for the loan too. So, if you fail to make the payments, the lender will go to them instead. The process is risky, so you’ll have difficulty convincing people to do it with you. 

  • My application keeps getting rejected. Why?

The Equal Credit Opportunity Act ensures that lenders don’t discriminate against borrowers while lending money. So, if a lender denies your application, you can ask why, and they’re legally obligated to tell you. 

The most common reasons for lenders to deny your application are bad or limited credit history, paperwork errors, and unstable income. If you make mistakes in your application, it isn’t unusual for the lender to reject it. 

If you have a bad credit history, the lender won’t trust you to be able to afford the loan. On the other hand, if you have little to no credit history, lenders will be reluctant to give you money because there’s no way for them to gauge whether you can afford the loan. The same goes if you have unstable employment like freelancing. 

  • Do I need to get pre-approved?

Don’t get a pre-approval too early. First, look around and choose the best option. If you are still set on taking out a loan, visit different lenders to find the best rates. After you have chosen your lender, you can get approval for your loan. 

We don’t recommend too many pre-approvals because it can affect your credit report. Lenders will view you as a high-risk borrower if you have too many hard checks on your report. Thus, your credit score will decrease, and you’ll have a harder time securing a loan.  

  • What is negative equity?

Cars tend to lose much of their value as soon as you get in and drive the vehicle away. However, you still owe the original price. This imbalance in the amount you owe versus the car’s actual value is negative equity or an upside-down loan. This phenomenon harms folks without a down payment on their car or having a more extended repayment plan. 

That’s because the longer you have the car, the greater the upside-down loan. Thus, we recommend avoiding plans that span over six to seven years. If you have an upside-down loan, it can be harder to sell the car as you’ll owe your lender more than you get for the car. 

Additionally, if the car gets stolen, your insurance company will only cover the actual value of the car. Thus, you’ll be forced to pay the rest of the loan balance by yourself. Furthermore, you will have trouble getting a new loan because they will add the previous amount to it. 

  • Do I need GAP insurance for my car?

You can avoid an upside-down loan by getting GAP insurance for your car. This insurance usually covers the difference between what you owe for the car and its actual value. So if you lose your car to thieves or in an accident, the insurance would take care of all your balance.  

We recommend GAP insurance if you get your car without a down payment. We also recommend it if you have a long repayment plan or a low down payment. You can get GAP insurance from an auto insurance company or a dealership. The insurance folks will give you better rates, so we recommend sticking with them instead of the dealership. 

  • Can I refinance my loan?

Yes, you can. Refinancing refers to taking out a new loan to repay your existing loan. This method will help you save money if the interest rates have dropped or if you have improved your credit. That’s because you’ll get better interest rates for the newer loan. However, we recommend going to several lenders and exploring all your loan options since obtaining financing can be tricky. 

You also need to look closely at your loan contract. That’s because you shouldn’t refinance the same loan if your lender charges a prepayment penalty. Additionally, refinancing is a bad idea if you have an upside-down loan.  

  • What will happen if I can’t pay the loan?

Auto lenders have protection in such cases. Your lender is the lienholder for your vehicle. Hence, if you default or fail to make payments, the lender will take the car from you. Afterward, many lenders will sell your car to recover their amount.  

If the amount the lender gets from selling your car is not enough to cover the loan amount, you will have to cover the balance. Thus, you will pay for a car you will not get back. 

Defaulting will also hurt your credit and, subsequently, your chances of getting another loan. Even if a lender agrees to lend you money for an auto purchase, they will charge extremely high interest. 

  • Can I give my loan to someone else?

That depends on your lender. If you can’t repay the loan, you could look for someone to assume your loan. If the lender agrees, the new borrower must go through a credit check. The credit check will ensure that the new borrower can afford this loan. However, giving someone your loan means you’re giving them the car too. 

If you cannot make the payments temporarily, you can get a family member to assume the loan. This temporary change will stop the lender from repossessing the car, and you can pay the family member back later. 

Conclusion: Is Considering A Car Loan An Smart Move? 

That concludes our take on auto loan basics. Now that you know how these loans work, it’s just a matter of choosing the right car and lender. You need to compare the offers from different lenders. Then, go with the lender offering the best APR and payment plan. Some lenders charge less interest if you allow auto-withdrawal of the monthly payment. So be on the lookout for offers like that. 

Choosing a private lender is more likely to give you a great APR. However, you need to explore all your options. After all, you know your situation the best. Choose the payment plan you can afford and ensure that the car you choose is suitable for its job. Remember to read all the fine print and understand every requirement before the sign the final agreement.


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