How Do Car Loans Work?

If you’re looking to purchase or finance a new or used vehicle, understanding how a car loan works is essential. 

You may be wondering what kind of terms and interest rates can you expect, how you compare different car loan options to find the best one and whether there are alternatives to having a car loan.

Read on to learn about the complexities of car loans as well as helpful tips so you can find the best car financing option for you.

What is a car loan?

A car loan is a type of financing that allows an individual to purchase a vehicle and repay it through monthly installments over a predetermined amount of time. Car loans are typically available through lending institutions like banks, credit unions and online lenders. Many car dealerships also offer their own financing options through lending partners or through the dealership itself. 

Whether or not you can qualify for a car loan is typically determined by factors like your credit history, income, total loan amount and the down payment amount. All are unique to you and can affect the interest rate and terms you receive.

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How do car loans work?

Obtaining a car loan usually starts with researching different lenders to find one that offers competitive rates and terms that meet your needs. Here are the general steps you can expect: 

1. Research vehicles - Before applying for a loan, have the exact type of vehicle you want to purchase in mind. Consider factors such as make, model, features, price, and fuel efficiency, when making your decision. 
2. Choose a lending institution - Consider a bank, credit union, or online lender. You may also opt to go directly to a dealership that offers in-house car loans. Research different lenders and compare their rates before choosing which one is best for you.
3. Prequalify for a loan - The easiest way to find the best car loan option is to go online and prequalify. By entering in a little bit of personal and financial information, you could find out within a few minutes whether or not you have a chance of qualifying for the car loan amount you need to purchase the vehicle you want. 
4. Apply for a loan - The lender will assess your credit score, income, employment status and debt-to-income ratio to determine if you qualify for the loan. If you’re approved for the amount requested, the lender will then offer you specific terms on the loan, including an interest rate and length of the repayment period.

As of April 2023, average interest rates across all credit profiles are approximately 3.86% for new vehicles, and 8.21% for used. Repayment periods for car loans typically range from 24 to 84 months, depending on the loan amount and the borrower's credit history.

1. Compare offers - Once pre-approved for the loan amount you need, you can then start to receive offers from various banks, credit unions and online lenders. Compare each of the offers side-by-side to determine which car loan and lender makes the most sense for your financial situation.
2. Complete the application - When you find a loan you like, go ahead and complete the entire loan application process directly with the lender.
3. Receive funds and purchase the car - The funds will be transferred into a designated account and you can use the money to purchase your new vehicle. The funding process can take anywhere from a few hours to a couple of business days depending on the lender.

Car loan key terms

• Principal - The principal is the amount of money borrowed to purchase the vehicle. This includes fees associated with the vehicle purchase, such as taxes, registration fees and extended vehicle warranties. 
• Interest rate - The rate a lender charges to borrow money from their institution. Interest rates, or APRs, are typically expressed as a percentage of the total loan amount.
• Term length - The term length refers to how long it will take to pay off your car loan. Typically, car loans can range from 24-84 months (2-7 years).
• Monthly payment amount - Your monthly payment amount is determined by a car loan’s principal amount, interest rate, and term length. Your monthly payments may also include other fees like maintenance plans, taxes, registration fees and extended warranties. 
• Prepayment penalties - Some lenders may charge a prepayment penalty if you decide to pay off your car loan early. Before applying for a vehicle loan through a lender, make sure to read the fine print and make a note if there is a prepayment penalty. 
• Collateral requirements - Car loans are essentially secured or unsecured personal loans. A secured car loan requires the use of an asset like another vehicle, your home, or your savings account as collateral. If you happen to default on the car loan, then the lender has the right to seize the collateral to recover any potential losses.

What factors affect your monthly payment amount?

Before taking out a car loan, it is important to find a monthly payment amount that fits within your budget. The key is a number you are comfortable with that keeps the total interest amount as low as possible. 

Here are the main factors that determine your monthly payment:

• Loan amount - The larger the loan amount, the higher your monthly payments will be. 
• Interest rate - A lower interest rate means lower payments each month, while a higher interest rate means higher payments each month. Shop around from different lenders to make sure you get the best deal possible.
• Loan term - The length of time it takes to pay off a car loan also affects your monthly payment amount. Longer terms mean smaller monthly payments but more overall interest. Shorter terms mean larger monthly payments but less total interest over time. 
• Down payment - Making a down payment reduces both the size of your loan and its associated costs such as interest and fees. Try to put as much money down as possible as this can help reduce your principal balance, interest rate and total interest paid over time. 
• Credit history - Your credit history plays an essential role in determining not only whether or not you qualify for a car loan, but also what kind of rates and terms are available to you. Usually, borrowers with higher credit scores will have access to better deals than those with poorer credit scores or no credit history at all.

4 types of car loans

Here is a quick breakdown of the different types of car loans you may encounter while searching for financing: 

1. Secured Car Loans - Secured car loans require the borrower to provide some form of collateral (like your home or savings account) that can be used to secure the loan. Secured car loans typically have lower interest rates than other types of loans because they are backed by collateral. 
2. Unsecured Car Loans - Unsecured car loans do not require any form of collateral to secure the loan, and instead, are based solely on your credit history. These types of loans usually come with higher interest rates than secured loans, however, they are the most common type of car loan out there. If you default on an unsecured car loan, then the lender has the right to repossess the vehicle and report the loan default to the credit reporting agencies. A car repossession can greatly impact your credit score and make it difficult to get new credit in the future. 
3. Hire Purchase Agreements -  A hire purchase agreement involves making regular payments over a set period until the full amount owed is paid off. Once the full amount is paid off, ownership of the vehicle transfers from the lender to the borrower. 
4. Balloon Payment Loans - Balloon payment loans involve paying off part of the loan in one lump sum payment at the end of the loan term. This kind of loan structure can help reduce monthly payment amounts and overall interest, however, it is the responsibility of the borrower to save enough money to make the large lump sum payment at the end of the term. If not, additional fees may be added on or a second loan may be required to make the balloon payment. Both of which are not ideal. 

How are car loans paid back?

To pay back a car loan, you need to make regular monthly payments to your lender for the duration of the repayment period. These payments include the principal, interest, taxes and any other applicable fees. It is essential to make these payments on time each month to prevent any additional charges and to protect your credit score. 

Once all the required monthly installments have been made on time and in full, the debt is absolved and the borrower is granted 100% ownership of the vehicle. 

Disadvantages of car loans

The main disadvantage of taking out a car loan is having a new monthly payment to pay for each month. A new monthly payment can eat into your monthly budget as well as limit the amount of money you can put into savings or other investments. 

Here are some of the other disadvantages to consider before taking out a car loan.

• Total cost - A car loan increases the total cost of owning a vehicle as they require interest payments, which can add a significant amount to the overall cost of a vehicle over time.
• Ongoing financial commitment - Monthly payments can put a strain on your monthly budget, and any changes in financial circumstances like a job loss could make meeting these financial obligations difficult. 
• Depreciation - Vehicles typically lose value over time. Depreciation can be even more rapid than the rate that you pay off your car loan. You may end up owing more on your vehicle than it is worth. This is known as being "underwater" on your vehicle. 
• Limited flexibility - Car loans often come with strict terms and conditions that limit flexibility in modifying payment plans or selling the vehicle before the term ends without facing penalties.

An alternative to car buying

If buying a car isn’t for you at this time, you may want to consider a car subscription. 

With a FINN car subscription, you can drive one of the latest and most popular car models on the road for one low monthly payment. Roadside assistance, insurance and maintenance are covered by the monthly rate. Approval only takes a few minutes, and once the car is available, it will be shipped directly to your doorstep. Browse through our available models.

Final thoughts

Sometimes a car loan makes sense if you are looking to purchase a new or used vehicle, and sometimes it does not. If a car loan isn’t the right choice for you at this time but you still want the freedom of driving a car, consider a FINN car subscription.