When you’re shopping for a car, you have to consider more than just the sticker price. If you’re taking out a loan to buy the car, whether it’s new or used, you’ll be paying interest over the lifetime of the loan.

Your monthly payments won’t just go toward paying down that purchase price. They will go toward your owed interest as well. Lengthier terms and higher interest rates mean more paid over time.

How auto loans work

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

You can get one of two kinds of loans: a secured auto loan or an unsecured auto loan. Most auto loans are secured, meaning the vehicle is collateral for the loan. If you fail to make payments, the bank can repossess the car. Unsecured loans are made without collateral, but missed payments will hurt your credit score or could result in your loan being passed on to debt collection agencies.

The process for getting either type is similar, but with an unsecured loan, you’ll receive the title immediately upon purchasing the car. 

1. You apply for an auto loan

The first step to getting an auto loan is applying for one. Most financial institutions will offer auto loans, including national banks. You can also shop around at local banks and credit unions or use online lenders, which tend to have faster approvals. 

To speed up the process and preview your loan terms, you can get preapproved for a loan. This requires a lender to perform a credit check and generate a formal offer for you before you officially apply.

2. The lender assesses your creditworthiness

Once you apply for an auto loan, the lender that you choose will assess your creditworthiness to determine the terms of the loan that it will offer you. Typically, the financial institution will consider your credit score along with your existing debts, as well as any late payments or other potential red flags that may appear within your credit history. Some banks will want to see your banking history to assess how much cash you have available to you, as well. 

Every lender weighs these details differently.

3. The lender sets the amount you can borrow and your APR

The amount you can borrow and the annual percentage rate (APR) for your loan are 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.

4. You repay the loan over a set term

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 24 to 84 months.

For example, a $20,000 loan with a five-year term and a 6.00 percent annual percentage rate would result in just under $3,200 total interest paid. The same amount and rate for a three-year term would be just $1,904 in total interest.

You can also refinance your loan once you’ve made payments on it for a while. This can extend or shorten your term and potentially improve your interest rate. You can refinance with the same lender or a new one and shop around for terms that fit your needs.

5. At the loan’s end, you own the car

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

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.