How Do Car Loans Work?

A car is a large purchase, so it makes sense if you need to take out a loan. You’ll want to look at your budget and determine how much you can afford as a monthly loan payment. You should also consider your credit score and down payment amount, both of which will factor into what loan terms lenders may offer you.  

Car Loan Definition

An auto loan is a type of secured personal loan. Your car acts as collateral for your loan – if you default, the lender has the right to repossess your car to recoup their costs. Similar to unsecured loans, you will take out a lump sum and pay it back over monthly installments.

The amount you borrow will be based on the car’s purchase price and any down payment you offer upfront. Interest rates and terms will differ depending on the lender and what you may qualify for based on your financial profile.

Key Terms To Understand When Getting A Car Loan

Part of knowing how auto loans work is understanding the terminology. That way, you’ll know what you need to look for when comparing loans and how to increase your chances of qualifying for one.

Some key terms to get familiar with include:

• Annual percentage rate (APR): Your APR is the interest rate plus any applicable lender fees you’ll pay. It’s a more accurate comparison than interest rate alone, since it shows all the costs you’ll pay for your auto loan.
• Down payment: This is the amount you pay out of pocket as part of the purchase of the car. It will reduce the amount you need to borrow. Some auto loan dealers or dealerships may require you to put a certain amount down.
• Term length: How long your loan will last. For example, if your term length is 36 months, you will be making payments for that amount of time.
• Collateral: An asset or amount of cash you put down to secure a loan. Collateral is to reassure the lender that if you default on your loan, it can recoup their losses. The vehicle is the collateral for an auto loan.
• Credit score: This three-digit number represents your credit behavior, like your payment history, how many loans you’ve applied for and any negative marks like bankruptcy. The higher your credit score, the more likely lenders think you are to pay back loans on time.
• Loan-to-value ratio (LTV): This ratio is used by lenders to assess how much risk there is when approving your loan. You can calculate LTV by dividing the auto loan amount by the car's value.
• Monthly payment: Your monthly payment is how much you’ll pay the lender back each month in principal and interest. Fixed-rate loans have the same monthly payments, whereas variable-rate loans may fluctuate.
• Preapproval: Getting preapproved means that the lender has assessed your financial profile and indicated it’ll most likely approve you for a loan and at what terms. You will typically get a preapproval letter you can show to a car dealership to prove you have the means to purchase a car.
• Default: When you default on a loan, it means you can no longer make payments and the lender has the right to repossess your vehicle.

How Car Loans Work: The Basics

There are several factors lenders use when assessing an applicant for a loan:

• Credit score: Lenders use your credit score to determine how likely you are to pay back your loan.
• Income: Having a steady amount of income means that you’re more likely to be able to afford a car loan.
• Debt-to-income ratio (DTI): Your DTI is the percentage of your gross income going toward debt payments. The higher your DTI, the more lenders may believe you’re relying too much on debt. It could affect your chances of getting approved for a loan at a competitive rate.

Factors To Consider When Getting A Car Loan

When financing a car loan, it’s smart to consider how it can fit into your overall financial life. Some specific factors to consider include your car budget, your monthly payment due date and the lender you work with.

How Much Car You Can Afford

Budgeting for a car helps to prevent yourself from being stretched too thin financially. A general rule of thumb is to spend no more than 10% – 15% of your monthly take-home pay on a car payment. For example, if you get paid $3,500 a month after taxes and other deductions, then you should budget for $350 a month in car payments.

Where You Get The Loan

Choosing the right lender can save you thousands of dollars in interest. Shopping around helps you compare rates and terms and see which lender has the best features for your needs. Places where you can shop around for loans include credit unions, banks and online lenders. You can work with the dealer if you believe it'll save you time, though you may not get the best deal there.

When Your Monthly Payments Are Due

Knowing when your payments are due ensures you can make them on time. Being late on even one payment can have consequences, like late fees and a potential drop in your credit score. Consider enrolling in autopay through your bank to help with on-time payments.

The Bottom Line

Auto loans are a type of secured personal loan that uses your car as collateral. Before taking out a loan, be sure to shop around to increase your chances of finding a loan that best suits your needs. For help with figuring out your car budget and when payments are due, consider using free budgeting tools like the Rocket Money^℠ app.