How Do Car Loans Work?

A car loan is a type of loan that you obtain when you want to purchase a vehicle, whether for a new or used car. The lender agrees to set up an installment plan based on your financial circumstances, with monthly payments and terms outlined in a legally binding contract. You can obtain a car loan from several lending institutions that maintain vehicle ownership until you pay off the loan in full. 

Below are the basic steps involved in obtaining a car loan:  

1. Research vehicles: Although it may seem like jumping the gun to look before you can buy, figuring out what type of vehicle you want to buy is often the hardest decision. List out features you want and need and match those to a few makes and models to give you a starting point in your search. 
2. Shop around for lenders: You should compare lenders as much as you consider various vehicles for sale. Put lender rates and terms side-by-side on a single sheet of paper to figure out which works best for you, keeping an eye on lender requirements. 
3. Get preapproved: A preapproved car loan can help you negotiate a lower price and better terms, or solidify your preapproved offer as the best you’ll find. Remember, keep your preapproval credit checks within a 14-day period to consolidate your soft credit checks into one and minimize any credit score drop.  
4. Compare loan offers: Here’s where the rubber hits the road. Use your preliminary research to compare detailed offers from several lenders and determine which vehicles you can afford. 
5. Apply for a car loan: When you’ve decided which lender and car to purchase, apply for the loan with any necessary paperwork. Your terms may change slightly depending on your credit report and current interest rates. 
6. Sign the paperwork: If you opt for a loan outside the dealership, you’ll receive the funds to use for the purchase. Carefully review the contract before you sign it. Set aside funds for your first payment and enjoy your new car.

You can also explore other options, such as a FINN car subscription. Subscribing to FINN can help give you more time to decide—and test drive several vehicles to contextualize your purchase. 

If you’re unsure what credit score you need to buy a car or how long you can get a car loan for, beginning your education with a few key terms can help. Here are a few to get you started: 

• Principal: The agreed-upon price (or purchase price) of the vehicle comprises the bulk of the car loan principal. However, the principal may include any additional fees or amounts, including registration fees and taxes, vehicle protection plans, and extended warranties. 
• Monthly payment: Your monthly payment includes a portion of the interest, principal, and other related expenses across the designated loan terms. Most monthly payments initially pay off the car loan interest, while subsequent payments reduce the principal, but it varies by lender. 
• Interest rate: Based on the borrower’s credit score, the interest rate determines how much it costs to borrow the car loan amount. Interest rates favor those with higher credit scores as they represent less risk to a lender. 
• Term length: Most auto loans come with terms of 24 to 84 months. Shorter terms incur higher monthly payments with less interest paid, but longer terms increase interest payments and lower monthly payments over the life of the loan. 
• Prepayment penalties: Some lenders fine you for paying off your car loan early with prepayment penalties. Whatever you might save in interest payments, you’ll likely pay for with prepayment penalties.

Any time you come across a term you don’t know, take a minute to look it up to better understand not only the term itself but also how it affects other facets of a car loan. Understanding the inner workings of car loans will help you better approach your next purchase, regardless of your budget. 

There are two main types of car loans available: 

• Secured: These car loans require collateral in the form of another asset, most commonly the financed vehicle itself. The collateral acts as insurance and compensates the lender should the loan go into default. Most secured auto loans feature lower interest rates. 
• Unsecured: The majority of car loans fall into the category of unsecured. If you default on your car loan, the lender can repossess their property and report your delinquency to any or all credit bureaus. Interest rates tend to be higher based on the borrower’s credit history.

Regardless of which car loan type you choose, you can make a balloon payment at any point to pay off the loan. Balloon payments are lump-sum payments that significantly reduce your principal or pay it off entirely. Some lenders charge prepayment penalties if you pay off your loan early, so read the fine print before making a balloon payment. 

The annual percentage rate (APR) on a car loan represents the interest you pay on the loan and any other associated financing fees. Figuring out how to calculate APR on a car loan requires simply knowing the principal finance amount, the interest rate you qualify for, and any associated lender fees. You can easily compare lenders based on their APRs, from how much they charge in administrative fees to what it costs to originate the loan. While your credit score factors into the APR on a car loan, any additional fees are often non-negotiable and predetermined by the lender. 

You can obtain a car loan from several lending or financial institutions, including: 

• Banks 
• Credit unions
• Online lenders
• Dealerships

No-credit-check/no-proof-of-income car dealerships may also offer auto financing. You can also look into buy here pay here dealerships for an auto loan. Comparing rates between lenders will help you find the best loan terms, given your financial situation. 

Car loans work well for borrowers with a solid financial foundation for the foreseeable future (three to five years), high credit scores, and enough savings for a down payment. Low debt-to-income ratios can also help borrowers afford a car payment, initially and over the loan. Adding another vehicle to the mix as a trade-in can really stack the cards in your favor. 

For many people, car loans come as a necessity. A credit score above 680 is ideal for getting the best loan terms without signing up for staggeringly high interest rates. However, sometimes the best move is to improve your credit score, lower your debt, or increase your income before obtaining a car loan. These changes alone can boost your ability to get a car loan and terms that work with your budget, not against it.