How Do Car Loans Work?

If you’re buying a car, you may need to take out a car loan. Learn how your down payment, term length, and interest rate will affect what you pay each month.
Written by Melanie Reiff
Reviewed by Jessica Barrett
Updated on Apr 27, 2022
Buying a car is a major expense, and it will generally necessitate taking out a car loan. While car loans are very common, the process—from making the application to negotiating a good interest rate—can seem quite complicated. 
New cars aren’t cheap. The average price for a new car is roughly $45,000, according to Kelly Blue Book. As such, most consumers can’t purchase a new car outright and will need to apply for a loan. 
Several steps go into applying for and securing a car loan, and it’s best to learn what to expect beforehand. Luckily, the
car insurance
comparison and broker app
has compiled everything you need to know about car loans. 

What is a car loan? 

If you’re looking to buy a car but don’t have the cash to cover the full price, you’ll need to borrow money to make the purchase. A car loan is a loan specific to purchasing a vehicle, unlike a personal loan, which can be used for multiple purposes. 
When you apply for a loan, the lender will determine the risk of giving you money—based on your financial history—and lend you a lump sum to be paid back with interest. By signing the loan contract, you agree to pay that money back over the set term of the loan. 

Key car loan terms

Car loans can be complicated—there’s a fair bit of terminology to wrap your head around. Here are some common terms to understand before you enter your loan contract: 
  • Total Cost: This is the total amount of the loan, including the principal and interest.
  • Principal: The amount of money you are borrowing—excluding fees, penalties, and interest.
  • Loan Term: The loan term is the length of time you have to pay back the total cost. Terms often range from 36 to 72 months. You’ll pay more each month with a shorter loan term, but you’ll have to pay more total interest over a longer loan term. 
  • Down Payment: A down payment is the amount of money you pay out-of-pocket when you purchase a car. The more you pay upfront, the less you’ll be on the hook for in the long run—and the lower your interest rates will be.
  • Annual Percentage Rate: Your
    annual percentage rate (APR)
    includes all your interest and extra fees and is listed as a yearly percentage of the total loan. The higher the APR, the more you’ll need to pay over time.
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How does my car loan work? 

When you apply for a loan, you’ll come to an agreement with your lender on the terms of your loan—including the term length, monthly installments, and interest rate. 
You will pay back the loan in monthly payments. Each monthly payment will be broken down into principal and interest, so you know exactly how much you’re paying toward the overall price of the car each month.
Pro Tip Sometimes, your very first loan payments will go exclusively toward interest, so don’t be surprised if your principal number doesn’t budge until a few months in. 

What are the most common types of loans? 

There are two main types of car loans: a new-car loan or a used-car loan. The process for applying for each is roughly the same, but you may find that a new-car loan comes with a lower interest rate than a used-car loan. 

What are term lengths?

Car loan terms are expressed in months, often ranging from 36 to 84 months. The average length of car loans has increased in recent years due to the rising cost of vehicles. 
The most common car loan terms are currently 60 to 72 months. While you’ll have lower monthly payments with a longer term, you’ll pay more in interest throughout a long-term loan than a short-term one. 
Keep in mind that your car loses value (depreciates) over time, so you may end up
upside down
on your loan and paying more than your car is worth if you opt for a longer loan term.  

How does your down payment impact your car loan? 

Having a larger down payment ready is to your advantage. The more you pay upfront, the less you’ll have to pay over time. 
For example, if the total value of the car is $40,000 and you put $10,000 (25%) down, you’ll only need a loan for the other $30,000. This lowers your principal and your monthly payments compared to taking out a full $40,000. 
Key Takeaway A car loan is the money you borrow to cover the cost of a vehicle. The amount you pay for a car loan is determined by the cost of the vehicle, your down payment, term length, and interest rate.

What is the average interest rate on a car loan? 

interest rate
is a percentage of the principal you’ll pay to your lender based on the total amount you borrow. This is like your lender’s charge for allowing you to borrow money and compensates the lender for any potential loss on their investment. 
Multiple factors determine your interest rates, including: 
  • Credit score
  • Credit history
  • Loan term
  • Type of vehicle
  • Down payment
The better your
credit score
and credit history, the lower your interest rate will be
Most lenders want to guarantee they make a profit—so they charge higher interest rates to borrowers who are more likely to default on the loan (like those with low credit scores or bad credit histories).

Where do I get a car loan? 

You can get a car loan from most financial institutions or dealers. However, it’s best to shop around to find a lender that will give you the best deal. 
Compare terms from different lenders—including dealerships, banks, and
credit unions
—and determine which will be most financially beneficial to you. You may find that a bank or credit union gives you a better deal than a dealership.
Additionally, beware of predatory lending institutions when applying for a loan. These institutions often make it easy to apply for financing, but they will charge you very high interest rates and unfavorable loan terms. Be sure to do your research before signing a contract. 

How do I apply for financing? 

To apply for a car loan, you’ll need to complete a loan application from the dealer or financial institution. Typically, you’ll need the following information: 
  • Social security number
  • Employment information
  • Current and former address 
  • Total income and sources of income 
  • Other debt information
You’ll typically go through a pre-approval or pre-qualification process, where the lender will pull your credit history to see if you qualify for a loan. Note that this process involves a hard check on your credit, which could cause your credit score to dip slightly. 
If the lender determines you qualify for a loan, they will draw up a contract with the term length, principal, and APR for you to review.

How do I lower my car loan interest payments?

The best way to lower your interest payments is to complete an
auto refinance
, which allows you to renegotiate the terms of your loan.  
To refinance your loan, you’ll go through the same application process as you did for an initial loan. If your credit score has improved since your initial application, you may be able to negotiate a lower interest rate. 
Additionally, you could shorten the terms of your loan, which would lower your interest payments over time. 

What if I can’t pay back my loan?

If you can’t pay back the money you borrowed, you run the risk of defaulting on your loan—in which case the lender can repossess your vehicle. You do have a few options before you get there, however. 
First, you could talk with your lender about getting an extension on your due date or a payment referral. You also could work out a payment plan if your lender is amenable. 
Finally, you could try to refinance your loan with a
—someone who would be on the hook for payments if you couldn’t make them. But, keep in mind, if you default on your loan, it will also impact their credit score.

Finding affordable car insurance

One more thing—your lender will require you to have full coverage car insurance if you get a car loan. While full coverage is the best at protecting you and your vehicle if you’re in an accident, it isn’t the easiest on your wallet.
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Once you find a policy that works for you, Jerry will help with all of the paperwork and sign-up—so you get the coverage you need with none of the hassles. 
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