An auto loan is a method of financing that allows you to purchase a vehicle by borrowing money from a lender. The loan is then repaid over a set period, usually two to seven years. The monthly payment amount is determined by the loan size, interest rate and term.

How auto loans work

Approval for a car loan works much the same way as other types of financing. The lender reviews your application, assesses your credit score and financial situation and determines your creditworthiness based on several factors.

The lender will require proof that you can afford the car and that you have a sufficient source of income. In most cases, this means you must have a job with a steady income and a minimum credit score that varies by lender, although there are exceptions. Even if you have a good credit score, the lender will look at other factors to determine whether you are a good candidate for an auto loan.

Once you are approved and the lender issues you a car loan, you will make monthly payments over a set schedule for 24 to 84 months.

Auto loan amounts

The amount you can borrow for a car is based on your monthly income and expenses, your credit score and your debt load. Your down payment will also affect how much you can afford. If you are shopping for a $40,000 vehicle, for example, but can only get approved for $35,000, a $5,000 down payment will put you in a position where you can still purchase that vehicle.

Auto loan interest rates

The interest rate on your car loan depends largely on your credit score, loan amount and term and lender. The best rates go to borrowers with very good to excellent credit — typically a score of 740 to 850.

If you want to get the best rate, check your credit report and request corrections if needed. Corrections should be requested at least 30 days before you intend to apply — this allows. You should also prequalify with at least three lenders, rather than going straight to the dealership. This will ensure you get a good deal.

Auto loan terms

The length of your car loan affects your monthly payment and how much interest you pay in total. The shorter the term, the higher your monthly payment will be — but you’ll also pay less interest, because it will have less time to accrue. Most car loans are for a term of two to seven years.

Take, for example, a $20,000 loan with a five-year term and a 3 percent interest rate would result in $1,562 total interest paid. The same amount and rate for a three-year term would be just $938 total interest.

Auto loan payoff

The payoff process is straightforward. You’ll make regular monthly payments until you’ve paid off the full amount of your car loan. Once it’s fully paid off, you will receive the title for the vehicle. You may also be able to refinance the loan before it’s paid off if you are able to get a better interest rate, but this process is not guaranteed.

Auto loan terms to know

It’s important to understand the components that make up an auto loan. Knowing these terms and what they mean will help you better understand the product and what you’re signing off on when you go to finance your vehicle.

  • Loan term: This simply refers to how long you will be paying back the loan. The longer the term, the more expensive your loan will be overall due to interest accrual. It’s sometimes called the loan period or repayment term.
  • Interest rate: The interest rate is the percentage that you will be charged for borrowing funds, but it does not include fees.
  • APR: The annual percentage rate (APR) is the interest rate you will be charged for borrowing the money, including fees. It also accounts for the term of the loan.
  • Down payment: This is the cash amount that you pay upfront when you buy the car. It’s recommended that you make a down payment equal to 20 percent of the total cost.
  • Amount financed: This is the amount you borrow, and it’s usually based on your income and ability to repay the loan. It’s also referred to as the loan amount.
  • Monthly payment: The monthly payment is exactly what it sounds like: the amount you pay towards the loan each month. It’s based on the auto loan’s term, amount and interest rate.
  • Total cost: Once you factor in the loan amount and the interest paid over the life of the loan, you will have the total cost of the loan.

Direct vs. dealership financing

There are two main ways to finance a car — directly through a bank, credit union or online lender, or through a dealership. Direct financing, also known as a “bank loan,” is when you apply for financing through a bank, credit union or online lender without going through a dealership.

Dealer financing is when a dealership works with a lender to offer you financing. The dealer sends your information to a number of partner lenders and will offer financing based on what it receives back.

While convenient, dealer financing tends to be more expensive than direct financing. There is often a mark-up added to the interest rate you pay for the loan — a commission that the dealership takes.

Next steps

Understanding how auto loans work and the several types of loans will help you make an informed decision when it’s time to buy a car. And with a little planning, you may even be able to save more money.

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