What is an auto loan and how does it work?
Key takeaways
- An auto loan is necessary to purchase a vehicle without paying cash upfront.
- Each month, you’ll pay a fixed amount toward the principal and interest over a defined period.
- You can use dealer financing to purchase a vehicle or arrange auto loan financing through a bank, credit union or online lender.
- Compare the APR, loan term and fees before formally applying for an auto loan to ensure you’re getting the best deal for your finances.
If you want to buy a car without paying entirely in cash, you must apply for vehicle financing. An auto loan is the money you borrow to pay for the vehicle. It includes the vehicle’s purchase price, interest and any applicable fees.
Comparing your options and getting the right loan could save you hundreds or even thousands of dollars. Understanding the key terms of an auto loan will help you do just that.
What is a car loan?
An auto loan is a type of installment loan that allows you to borrow money from a lender to purchase a car. You’ll repay the loan in fixed installments over a set period, and interest will be charged on the money you borrow.
Your credit score helps determine the required down payment and the loan amount you can borrow. A score in the mid-600s or higher may qualify for a lower interest rate, saving you money.
Those with a bad credit score may have more trouble securing an auto loan with competitive rates. Lenders tend to view lower credit score borrowers as riskier, resulting in higher rates. If you have a low credit score, consider looking for a bad credit auto loan, which has more lenient acceptance criteria. You can also wait to buy a car until you improve your credit score.
Key terms to know when getting a car loan
- Interest rate
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This is an annual fee the lender assesses to borrow money. A higher credit score or shorter loan term generally equals a lower interest rate.
- Annual percentage rate (APR)
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The APR is the total borrowing cost of the loan, including the interest rate and other fees, expressed as an annual percentage.
- Down payment
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The down payment is the amount paid to the lender before taking out the loan. It will be applied toward the total purchase price. The more you put down, the lower your monthly payments will be.
- Monthly payment
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The monthly payment is exactly what it sounds like: the amount you pay towards the loan each month. What you’ll pay is based on the auto loan’s term, amount and interest rate.
- Loan term
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The loan term or repayment period is the window of time during which you’ll make payments on the auto loan. The term is usually expressed in months or years.
- Principal
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This is the amount you borrow to purchase the vehicle minus the interest and fees. The principal plus the down payment equals the cost of the car.
- Total cost of the loan
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This figure includes the principal, interest and fees paid to acquire the vehicle.
How auto loans work
Once you compare auto loan lenders, apply and get approved, you will receive a lump sum to purchase the vehicle. Following that, you will make monthly payments to repay the loan, plus interest and fees. If you do not repay the loan, you risk losing the vehicle, as it serves as collateral.
The type of loan that’s best for you depends on factors like your credit score, the loan amount and the vehicle you want. Lenders typically like to see regular income, a low debt-to-income (DTI) ratio and a good credit score. The stronger your credit score is, the more competitive your rate will be.
Types of auto loans
There are three financing options to choose from: dealer financing, car loans from banks or credit unions and loans from online lenders.
Dealer financing
Dealer financing is the easiest way to get an auto loan, but not always the most cost-effective. You can do your shopping and financing in one spot. The dealer will likely perform a hard credit check. If you have a strong credit score, you may qualify for a promotional rate from the manufacturer if you go through a certified dealership.
However, dealer financing tends to come with a higher interest rate. Dealers often take a commission or markup when they match you with financing from a bank or credit union.
Bank or credit union auto loan
Traditional banks and credit unions offer auto loans if you don’t want to go through a dealer. However, it may take more time than going through a dealership. Generally, expect to wait between one business day and a week to get a loan from a bank or credit union.
Your lender can prequalify you for an auto loan without impacting your credit. You’ll get an estimate of your rate, term and borrowing limit, and you’ll have more negotiating power when you visit dealerships.
Online auto loan
You can also apply for an auto loan online. These loans are often processed remotely, but the steps are similar to getting a car loan from a bank or credit union. It can take less than one business day to get approved, depending on the lender.
Online lenders may be more likely to work with borrowers with subpar credit scores. Some even offer favorable bad credit auto loan rates.
As a borrower, you can choose between financing your purchase through the dealer (indirect financing) or finding and securing a lender yourself (direct financing). Indirect financing is convenient and can open options for borrowers with bad credit. But you will likely find more competitive rates when shopping on your own for a loan.
How to compare auto loans
The best way to compare auto loans is to look at the key costs — including interest rate, term and fees. Look at both the estimated monthly payment and the total paid over the loan term.
Annual percentage rate
The APR is one of the most important numbers when deciding on a loan. It determines total borrowing costs. An APR is set based on your credit score, income and the term and amount of the loan.
Expect a higher interest rate if you’re in the market for a longer-term loan or if your credit score is fair or poor. A shorter loan term or higher credit score means you’ll likely have access to better rates. The lender will also factor in fees, so review the loan’s structure.
Ideally, you want a lower APR to get a more affordable monthly payment and keep more money in your pocket. An APR just a few points higher could make the loan far more expensive.
The average new car loan rates for consumers with excellent and very poor credit were 4.77 percent and 15.75 percent, respectively, according to Experian’s Q4 2024 State of the Automotive Finance Market report.
To illustrate, imagine you get a 48-month, $36,000 auto loan. Here’s what you’ll pay each month, along with the total amount you’ll pay in interest over the loan term:
| Interest rate | 6% | 8% |
|---|---|---|
| Monthly payment | $845 | $879 |
| Total borrowing costs | $4,582 | $6,186 |
Term
You have a set number of months to repay your auto loan. A typical auto loan term ranges anywhere from 24 to 84 months.
If you plan to purchase a new car and keep it for a long time, you’ll owe a lower monthly payment by taking out a longer-term loan. But you’ll pay more interest over time and be charged a higher interest rate. To save, choose a shorter term. Just make sure the payments are well within your budget.
For example, assume you’re approved for a $36,000 loan with an interest rate of 6 percent. Take a look at the payments and interest costs for different loan terms:
| Loan term | 36 months | 60 months |
|---|---|---|
| Monthly payment | $1,095 | $696 |
| Total borrowing costs | $3,427 | $5,759 |
Fees
The two main fees you may see are the origination fee and the documentation fee. The origination fee is the amount you pay to secure the loan. The documentation fee covers the lender’s costs for securing your loan. You could encounter other fees if you finance through a dealer, but many of those fees are negotiable.
You should run the numbers before getting an auto loan so you’ll know what to expect. Use the Bankrate auto loan calculator to compare borrowing costs on auto loans with different rates and terms.
Bottom line
A car loan is an agreement between the lender and you, the borrower, allowing you to borrow money for an agreed-upon term to purchase a vehicle. While getting a car loan can be more complex than a personal loan, it is still possible to do it yourself and land a good deal. It just takes time and research.
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