How Car Loans Work (2023 Guide)

Quick facts about car loans

Buying a car is certainly a critical step in the life of most Americans, and many times it cannot be accomplished directly by paying in cash: the average price of a new car in the U.S. is roughly $38,000, according to Kelley Blue Book. The last quarter of the 2019 report of the Federal Reserve shows that roughly one-third of Americans, that is to say, 115 million people, pay a car through loan financing. This is done through a dedicated loan that is made available from banks, credit institutions, online lenders, or also from car dealers. Before choosing the borrowing route, you may want to have knowledge of its fundamentals, so that to be prepared in front of your prospective offers, and possibly not risk leaving more money than necessary on the table.

Features of auto loans

A car (or auto) loan differs not too much from a traditional loan, having interest tailored to its size and duration, and coming with specific fees; it isn’t the only way to fund your purchase, but it is likely to be the most convenient. It can be used either for a new or used car: you borrow the necessary amount from a lender among different choices, and as with any loan you must give it back in a set term, plus the interest and some mandatory service fees.

Car loans are secured loans, which means that if you become unable to repay what you borrowed, the car itself would act as collateral, thus the lender has the right to regain possession of the vehicle and sell it; this also implies that you won’t be walking into other bad consequences, such as garnished wages unless the lender can’t recoup what you owe because of a severe depreciation of the car.

Auto loans have the “simple interest” feature, so interest is determined just on your outstanding principal balance, as in contrast would be if it was compound (where it is calculated over principal plus existing accumulated interests); in other words, there won’t be interest accruing over previous interest applied to a schedule of past payments, so the interest amount can’t grow further adding up to the cost of the loan. This is of course an advantage in comparison with loans that impose a compound interest, such as business loans.

So you have a flat percentage applied only to the borrowed sum. As the total balance decreases because of the monthly payments, the amount of interest will accordingly diminish. Assume you have a loan of $25,000 with a 6% interest rate, to be paid in 60 months, so your monthly payments are $483.32, including $125 of interest for the first month. In the following month, you will have an interest amount of $123.21, the remainder goes to the principal, and so on for the next months.

This also refers to as auto loan amortization: the greater portion of your payments is made towards interest at its beginning (and the lesser toward principal); it also implies that if you will make early payments to shorten the loan term, pending interest will be charged upfront.

Interest rates on car loans change daily and vary depending on market indexes, the car of choice, if it’s a new or used car, dealers or lenders of choice; factors that give more stability to rates are your individual ones, such as your credit score, amount to borrow and loan term.

Interest on car loans are normally not deductible from taxes if you are using the vehicle just for personal driving; however, you may be able to deduct a portion of the interest if a few miles are covered for business purposes, which must be declared in the taxes form (schedule C). The percentage amount of the interest deducted will be calculated in proportion to that mileage.

Car lenders will also charge “late payment fees” if your monthly payoff isn’t made within a grace period of usually 9-10 days, which is a time window of tolerance beyond the date on which a payment is due.

Loan term, namely its duration, is balanced on the purchase value of the vehicle: a longer term will mean more comfortable monthly payments, but an increased overall cost of the loan because of interest; the definitive cost of your car will be anyway enlarged by taking an auto loan. Typical terms of a car loan are generally between 24 and 72 months, aka 2-6 years, but can go beyond these limits, depending on lenders; 36, 48 and 60-month lengths are commonest.

As with a mortgage, in a car loan you will be required down payment, a sum you put upfront: the bigger you can make it, the lesser you will pay overall because you extinguish the loan sooner, thus the amount of interest is reduced. Therefore, it is generally recommended to take the time for saving, so that you can put a meaty down payment, and pay less in interest.

APR (annual percentage rate) is not just the interest rate in itself but also comprehends some fees, such as origination fee. Different lenders will offer diverse APRs, that may include a variety of things besides interest, so it is imperative to carefully read their conditions.

On top of interest, you will have fees that are due basically for the loan related operations: they are the sales tax, origination/acquisition fee, and dealer charges, and generally can make up for an additional roughly 10% over the borrowing amount. Some fees are mandatory, while others are optional and can be negotiable or not. They can be embedded in the loan recurring payments, or paid upfront, which is likely to be required if you have a fair or less credit score, but would be best in order to avoid that interest accrue on such fees.

  • Sales tax are federal levies that most of the States apply on each car purchase, and usually constitutes the bulk of the fees: it can be anywhere between 2% and 6% of the car value, but it can go up to 10%, according to national and local rules
  • The origination fee is to compensate the servicer for the whole procedure of application, which consists of preparing all the paperwork, inquiring about you, and a bunch of calculations. It can be a flat dollar figure, or in most cases a percentage set to 1-2% of the loan amount
  • Title and registration fees are imposed for such operations
  • Destination fee is for covering the cost of the car shift from the factory (but you are likely to pay it anyway) and is several hundred dollars
  • Insurance fees for policies of three kinds: first, you can be offered temporary auto insurance that will cover you for accidents for a few months, depending on the dealer. However, a regular car insurance policy, providing full coverage is mandatory in the U.S. and will be anyway required by dealers. Credit insurance is optional loan protection for borrowers who during the loan lifetime may lose their job or get disabled, covering the difference of the unpaid amount. GAP insurance (guaranteed asset protection) is an add-on that takes care of the loan if the car is destroyed or stolen, paying off the difference between the car depreciated value and the remainder of the loan.
  • Extended warranty, with differing characteristics and limits based on car manufacturer.
  • Advertising fees imposed to compensate for the dealer’s cost of promoting the vehicle. They are not necessarily extra fees but can make part of the car purchase price (and of car loan), depending on cases.
  • Early payment fees. Some lenders may prevent you from shortening the loan term (thus reducing the interest amount) by applying such a penalty.

How does a car loan work?

Whatever the source of financing, being it lenders or dealers, modalities of an auto loan will be the same. As with any loan, you have to give back the borrowed money over a certain term, and this is made in monthly payments: each payment is made of the principal balance, which is the actual sum you took, plus an interest amount that is a percentage of the balance; fees are also paid, some of which may not be applied at all. When you have signed a contract with a car dealer, but finalized the loan with a lender, this one will transfer your payments back to the seller.

Lenders offer ranges of loan terms, and you choose 60/48/36 months or whatever duration depending on your budget availability: stretching too much the loan length for buying a not so expensive car isn’t going to be convenient because of the amount of interest, while a very short term such as 24 months might not be feasible because of high monthly payments to be faced. Many financial experts recommend to use the “20/4/10 rule”, where 4 is the loan term in years, 20 is the ideal percentage of your down payment and 10% of your gross income is how much you can spend on the car purchase.

You have still to find your sweet spot between what you can afford monthly and how much are you disposed to save on interest: to find out this, select two identical car loans in our calculator modifying only the loan term, and compare the results. Be mindful that you will usually get a lower rate from the same lender as you opt for a minor term. Besides, what is called “negative equity” is definitely a factor to consider as the term is concerned: this means that a car naturally depreciates, and with a longer loan, let’s say after six or seven years, you will still pay off the car value to purchase, which was greater.

Some lenders, like Capital One, lean on a network of dealers, with whom they work in a mutual relationship, and you will actually shop from those dealers; others are a network of lenders themselves, acting as mediators but they won’t finance directly your loan, which is done by their partners. In both the mentioned cases, you will have a variety of choices in a single marketplace: you will find that their advertised offers don’t have declared APRs or loan terms, or they can be in a range.

Loans for new cars tend to have lower rates than used cars. You should also bear in mind that some lenders don’t allow you to borrow for cars of certain manufacturers or of a special kind, for instance, electric vehicles.

Receiving the funds through a loan requires that you are approved first. However, there is always the chance to get denied: most of the time this happens because of questionable credit history, a suboptimal credit score, inadequate income amount or inconsistent source, too many pre-existing lines of credit, or even technical issues with compiling the form.

Some people prefer to make an auto loan leveraging on the trade-in of their current vehicles: this would mean giving away your old car and using a portion of its value to finance the new one, but most of the times it will be unseemly, compared with just selling the car; however, the sales tax applied to the new car will be calculated on its value minus the trade-in value (instead of on the price to purchase), resulting in a compensating little gain.

Refinancing an existing car loan is also possible, and sometimes it is a good move to get improved or just more suitable loan conditions for you, or even to obtain temporary debt relief.

A viable alternative to car loans are the more generic personal loans: peer-to-peer lenders, especially, might offer similar APR and turn out to be advantageous overall. That’s the case when there is a matter of qualification because of credit score: some private lenders might be more forgiving for borrowers’ less than good ratings.

Auto loan vs buying a car in full

The main reason one embarks on a car loan is, of course, short-term unaffordability of the car’s whole price. However, if you have cash available, you may want to consider the benefits of giving a lump sum once and have peace of mind later: above all, you won’t have monthly recurrences nor surplus to pay over the car price (interest and fees). Moreover, you get the car title soon, which means the asset is yours, while during a loan it is still legally considered as shared with the lender or dealer, and can be seized in case of your default with payments; still, you may need to modify the extent of insurance coverage on the car, change some of its components, or sell it without any limitations that you will have under a loan contract.

If you want to rest assured of how much you are going to spend on your car, buying it will do the job: with a car loan, you don’t know priorly unless doing the math, and may still incur late payments fees; that is to say, you have a greater expense in the long term, which might become troublesome to carry on top of other costs for things like a mortgage, etc.

Another plus is avoiding a so-called “underwater loan”(also known as “upside-down loan”): this means you are owing a certain amount to your lender, but in the meanwhile, the car value has depreciated, so you would actually pay more than it is currently worth. This is quite common, in fact, a car tends to see its value decreasing as it is driven off the lot.

On the other hand, taking a car loan can be beneficial for building your credit, whereas a car direct purchase wouldn’t have any effect: if you had a less than prime rating, but enough to qualify for a loan, making the effort to be punctual with all the payments in the short timeframe of three, four or five years will improve your credit score, and you will be in a better condition for using other financial services.

Lastly, you may want to consider an alternative to car-owning, that is leasing: this is about renting a car for a few years, with relatively advantageous costs, but under entirely different conditions compared to an auto loan.

Car loans and credit score

Knowing your credit score before applying for an auto loan is generally recommended, since it will let you know which rates and limits amount to check, and you will eventually apply for those deals. A free credit check can be conducted once yearly from one of the three U.S. credit bureaus: Experian, Equifax, or Trans Union: errors and/or omissions, possible reports of fraudulent activities can undermine your ability to get the loan. When one’s credit score is “non-prime”, that is to say below 660, options are lenders who have lower credit requirements, or using a co-signer’s score, in order to qualify or access to a more affordable rate; or, you may want to take the time to improve your credit status before getting a car loan, that can be done essentially paying off outstanding debts, for instance taking care of credit cards payments: consistency is of great help to your credit rating, that will go up over time, likely in a matter of months.

Your income and credit are, up to a point, mutually dependent, but credit in itself is the one that will determine your approval success: as you can see in the below table, having an excellent score will allow the best loan conditions,

Credit score categoryAverage loan APR for a new carAverage loan APR for a used car
Deep Subprime (300 to 500).14.25%19.81%
Subprime (501 to 600)11.51%16.88%
Non-prime (601 to 660)7.55%10.85%
Prime (661 to 780)4.75%6.15%
Super Prime (781 to 850)3.82%4.43%

Where to get a car loan?

Before proceeding to obtain any funding, it is common sense to come up with the affordability of your loan: you will anyway end up paying a car more with a loan, than with a direct purchase; rate choice is crucial, and you should arrive prepared at the dealership table. Using our budget calculator will help determine how much you can put into this loan.

After having shopped for car models, you are left with two main options for being financed: lenders and car dealers. Auto loan lenders can be: national banks, credit unions, private online specialized companies, peer-to-peer lenders, and car dealers; the latter usually have  partnerships with lending companies, otherwise lean on banks. Comparing the several options is your best bet if you want to save and find the most tailored conditions for your need.

Dealers should be considered next to lenders, at least if you are about evaluating choices on your own: before getting quotes from lenders not only may get you a better rate but eventually will make you prepared to face the dealership, if you decide to go that route.

Through dealership financing you accept both to buy and pay your car from the dealer, by taking a loan: indeed, dealers are likely to work with “captive lenders” who can offer catchy rates for the specific car make.

Dealership is essentially meant to save you time and the hassle of doing your own research, because you shop and take the loan to buy the car from the same place: since there can be multiple lenders involved, you might still receive more than just a “one size fits all” deal. Your credit score will be anyway taken into great consideration, in order to determine your final rate.

Car producers can come up with competitive rates; or, you can be prospected with multiple offers at once, but still, you have more limited choices than doing your homework. Moreover, it is certainly best to already have an idea of a reasonable rate to accept: to do so, you may want to get pre-approved from a direct lender. In some cases, you might be denied from lenders, while encountering dealers who are disposed to grant you the loan.

When it comes to dealers, you must read between the lines of the contract before signing, in fact, you can expect some “hidden” things such as fees you aren’t told in the first place: on top of the mandatory fees you will anyway have to pay with a car loan, you might have registration costs and additional ones, for instance, an early payoff penalty fee, embedded optional, e.g. credit insurance, etc.

Car makers can advertise very low rates, such as 2.9% and below, even zero interest, but those will be compensated by other costs, in order for the vendors to actually have a gain. Alternatively, they tend to offer incentives, mainly in the form of cash rebates, that can be suddenly applied to the car price to the purchase, and sales taxes will be calculated on car value before the rebate; on the other hand, depending on the State you live in, they can be deducted from taxes or not. Rebates are likely to apply almost exclusively to new cars.

How to get an auto loan?

When you turn to a lender, you will have a car loan form, where you are required to submit personal information such as Social Security Number, annual income and its source, as well as pending debts you may have. The approval process will necessarily require a “hard inquiry” on your credit score, implying a sensitive drop, although for a short period; this is best preceded by a pre-approval step, that will generate a rough estimate of your borrowing rates and main conditions, after having checked into your credit history.

Lenders today can offer pre-qualification and pre-approval options, which are both aimed to provide you a quote of your loan amount with its rate, based on the level of personal financial details you expose. By doing so, you can decide more confidently which offer will be the most convenient for you, then proceeding with its application.

Doing multiple pre-applications in a narrow time span, usually within 14 days, will be considered as a unique request on your credit history, so it won’t be harmful more than a single check; however, this is assuming that you will actually buy the car by finalizing the loan.

When you apply to a physical car dealer directly, you won’t have steps except for the final application, thus limiting your possibility of choice: going at the dealership with a pre-approval gives you more power to determine if the offered rates are worth them.

Pre-qualification vs pre-approval

Based on how much of your financial status information you decide to submit, you can obtain a pre-qualification or pre-approval. The consequences will be different: you can get “pre-qualified” when you provide moderate details, then you have a “soft credit pull”, and you obtain rates that can possibly apply for your condition, rates which are given in a range rather than fixed values, and that can change as you go through the complete application because lenders will get to know your complete financial profile. Rates you get from pre-qualification aren’t necessarily guaranteed at loan finalization.

When instead you are “pre-approved”, you have given a more comprehensive summary of your credit status, so you undergo a “hard pull” and in turn will get a more accurate prediction of prospective rates, very closer to the real values, but still relating to car type and its value: this gives you the knowledge and will guide you at best for the final choice. The hard pull then made with the actual approval won’t add up, but will count as one operation, assuming that you go through it in a window-period of 45/14 days (depending on the FICO score version the lender of choice is using) and that anything changed in the while, such as new credit lines opening or a diverse applicant involved, for instance, your son or wife. In every case, you are encouraged to not delay your decision too much.

The benefit of pre-approvals is to get interest rates quotes from different lenders: these rates are somewhat blocked for a short timespan until you actually sign the loan: when you are in a deal, you know that you have right to those rates, and can’t be potentially fooled by the dealer, in his/her attempt to make an exceeding profit. Again, the final rate will still depend on the car of your choice: on equal terms, you can’t expect the same rate for a small and a sports car.

Even if a bank or private lender allows you a pre-approval, telling you can afford the loan for certain rates, it doesn’t consider other expenses you have that factor in your budget such as mortgage payments, home, and car insurance, tuition financing, utility bills, etc. Lastly, it is still up to you to understand if you can embark on a car loan.

Which auto loan is best?

The number one factor to look at for choosing the best car loan is APR: even a 1% difference is meaningful, for some people also a 0.5%, which are perceived especially in the long run. The second factor is the repayment term, which will determine the size of your monthly payments and how long the APR will be applied: as discussed, you have to find the right compromise between low installments and saving on interest. Loan amounts limits are of course to be considered if you are about paying for an expensive car. Credit score requirements are a warranty for the lender that you will be able to give back the debt: for a certain lender, you can’t go below its declared score.

Lastly come possible benefits provided by the specific lender: for instance, some may have a great online experience, like a user-friendly desktop and mobile interface that let you set up an account from which to manage your payments; or you can be eligible for discounts (in the form of benefit on interest) if setting automatic payments.

Once you have more options, compare them into the calculator and see which one is the most feasible for your situation: you can figure out your monthly payments with different rates and terms, and looking into the amortization table you can see where you stand at a certain date.

Here you can choose among lenders who are established on the market, already known by customers, thus reviewed and trustable, offering the best rates, along with other favorable conditions for the loan: getting quotes will make you obtain pre-approvals or pre-qualification rates.

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