How Do Car Loans Work? Can I get One?

Last Updated: July 31, 2023 |
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Car loans are a very popular way to buy cars. According to recent statistics, Americans collectively have $1.36 trillion in auto loan debt. Yet despite their popularity, there’s still some confusion about how car loans work.

What’s the procedure of getting a car loan, from start to finish? In short, how do car loans work?

In this guide, we’re going to shine a light on the world of car loans and how they work. If you’re thinking of buying a new car, this invaluable information could help make your purchase far less stressful.

Are you ready to learn more? Then read on!

What Is a Car Loan?

A car loan is a specific form of credit that lets you buy a car over a longer period of time. Few of us can afford to buy a brand new car outright, but many of us can afford to pay a few hundred dollars per month.

When you get a car loan, you get the keys to the car and take on a loan balance that’s the value of the car, plus interest (usually). You agree to pay back this amount of money by the end of your term. You don’t actually own the car legally until you’ve paid it back: if you default on the loan, you’ll lose the car.

Usually, you’ll make a payment every month towards the loan balance. There are several factors that can affect the amount of money that you pay each month.

What Affects Loan Payments

The first factor that affects how high or low your loan payments are is the term of the loan.

Let’s say that you buy a car for $25,000 (not including interest). Over a 36 month term, you’ll need to pay $694.44 per month. Over a 60 month term, you’d instead pay $416.66 per month. The longer your loan term, the less you’ll have to pay each month, but you’ll also have to wait a lot longer to own the car.

You may also end up paying more with a longer-term loan due to interest.

The second factor that affects how much you pay is the interest rate of the loan, which can add tens of dollars per month to the cost of the car. While you can get interest-free car loans, these are very dependent upon you having a great credit score.

The third key factor is, of course, the amount of the loan itself. 

Let’s go back to that car from earlier, the one that cost $25,000, or $694.44 per month over three years. If you trade your old car in and get $5000 for it, this brings the loan amount down to $20,000 (excluding interest). This means that you’ll be paying $555.55 per month, instead. 

You don’t necessarily need to trade your old car in to knock the loan amount down either. If you’ve got a lump sum of cash that you can put towards the car, that will also bring it down.

Who Offers Car Loans?

If you’re thinking of getting a car loan, who are you actually going to borrow the money from? You’ve got two main options.

Borrowing From a Bank

Banks often offer auto loans, and these can be a great option, especially if you’re buying from a dealership that doesn’t offer good terms on a loan. You can shop around with banks and find a loan with better terms than you’d get from a dealership.

You may also be able to get preapproval for a loan, which can make the buying purchase easier. 

Dealership Finance

Often, a dealership won’t be able to offer you terms that are better than a bank. However, certain companies run promotions that can make them a much more attractive prospect.

This also means that you don’t need to go anywhere else. You can buy the car and sort out the loan in one fell swoop, which is very convenient. 

If you have poor credit, you should watch out for dealership loans that have high-interest rates, as these can be very bad for your long-term financial health.

A Quick Glossary

Before we take a look at the application process in detail, it’s worth refreshing your memory about what specific financial terms mean. Let’s get started.

Interest is the cost of borrowing money from a lender. It’s charged as a percentage of the loan, known as APR (annual percentage rate), which is based on the loan balance.

The principal is your loan balance, which should decrease each month.

The term of the loan is the total amount of time that the lender gives you to pay back the loan.

Total cost refers to the full cost of the car loan, including interest and principal.

How to Get a Car Loan

Now that we’ve covered common terms, let’s take a look at the steps that you need to take to get a good deal on a car loan. We’ll cover everything from starting the search to signing on the dotted line.

Understand Your Credit Score

Before you start applying for any loans, it’s worth taking a look at your credit score. This is a rating that determines your perceived trustworthiness and ability to repay a loan. If it’s low, you’ll have a harder time getting a loan on good terms.

There are multiple tools that you can use to take a look at your credit rating, and if it’s poor, you may want to take steps to repair it before you look for a loan. If it’s healthy, then we can move on to the next step.

Find the Right Loan for You

As we discussed earlier, you have a lot of options when it comes to getting a car loan. You can get a loan from the dealership if they have a good deal, or shop around and take a look at various banks or credit unions. 

It’s well worth researching your various options at this stage. Be critical and take a close look at the terms and incentives that different lenders offer.

In general, you should look for a loan that has the shortest term that’s still affordable, since interest adds up fast. You should also try to make a down payment or exchange your old car since this can reduce the total cost dramatically.

Start Your Application

Now comes the most exciting (and the most daunting) part of the car loan process: the application itself. There’s nothing wrong with applying to multiple lenders, as an application isn’t a legal agreement: until you sign the paperwork, you aren’t committing to pay anything back. However, you should be aware that when you make an application, your credit score will decrease slightly.

When you apply for a car loan, you’ll need to have a fair amount of paperwork to hand. You’ll typically need:

  1. Your driver’s license or another form of ID
  2. Proof of your income, which can be payslips or bank statements
  3. An address history

You may need more or fewer pieces of paperwork depending on the lender. Some may also ask for references.

Getting Declined or Approved

When you’ve submitted your application, you’ll have to wait for a while before you hear back, usually a few days but sometimes longer. If you get approved for the loan and you’re happy to commit to it, then you can sign the paperwork and get the car.

Before you sign the paperwork, make sure that you’ve read it thoroughly and that there are no nasty surprises lurking in the fine print of the loan contract.

If you get declined, don’t panic. While it can be very demoralizing to be declined for a loan, it’s also very common, as car blogs will tell you. It doesn’t mean that you can’t get your car, either, but you may need to shop around and look for another loan with different terms.

These terms can sometimes lead to a more expensive loan or may require a down payment. If this is the case, you may want to consider whether now is the right time to get a car loan, or whether you’d be better off waiting a little while longer and building up your credit score.

Set Up Automatic Payments

Missing a payment can result in serious problems, including late fees. Your best bet is to set up a direct payment with your bank to make sure that you can make the payments on time. Then, all you need to do is make sure that you have enough money in your bank account to make the payment.

How Do Car Loans Work: Answered

When you started this article, you wanted to know “how do car loans work?” We hope that you now feel a lot more confident in your knowledge of auto loans and what you need to do to get one. 

If you’ve enjoyed this post. If you’d like to read more in-depth blog posts about everything from car safety to the most iconic cars in history, take a look at the rest of our blog!