Short Answer
An auto loan is a type of installment loan that lets you borrow money to purchase a new or used vehicle and repay the lender through regular monthly payments. Your payment generally includes part of the loan principal plus interest and may also include certain fees. The vehicle typically serves as collateral, giving the lender a security interest in the car. Your interest rate, loan amount, down payment, and loan term determine how much you pay each month and how much the loan costs overall.
Detailed Answer
1. You Choose a Vehicle
First, you decide which car you want to purchase and determine how much you need to finance.
For example, if a vehicle costs $30,000 and you make a $5,000 down payment, you may need to finance the remaining $25,000, before considering taxes, fees, trade-in value, and other costs.
A larger down payment generally means you borrow less money and may reduce your total financing cost.
2. You Apply for an Auto Loan
You can usually obtain financing through a bank, credit union, online lender, or dealership-arranged financing.
Lenders typically consider factors such as your credit history, credit score, income, existing debts, down payment, loan amount, vehicle type, and loan term when deciding whether to approve the loan and what rate to offer.
3. The Interest Rate Determines Part of Your Cost
The interest rate is the cost of borrowing the money.
The APR is another important number because it provides a broader measure of borrowing costs and can include certain fees. When comparing auto loans, compare APRs with other APRs rather than comparing an APR with a basic interest rate.
For example, two lenders might offer the same $25,000 loan but charge different APRs. The loan with the lower overall borrowing cost could save you money over the repayment period.
4. You Choose a Loan Term
The loan term is the amount of time you have to repay the loan, usually expressed in months.
A shorter term generally means higher monthly payments but less interest paid over the life of the loan. A longer term can lower the monthly payment but generally increases the total interest cost.
For example, the CFPB gives an example of a $20,000 loan at 4.75%:
- 36 months: about $597 per month
- 48 months: about $458 per month
- 60 months: about $375 per month
- 72 months: about $320 per month
The longer terms have lower monthly payments but higher total interest.
5. You Make Monthly Payments
Once the loan is finalized, you make payments according to the loan agreement.
An amortizing auto-loan payment generally goes toward fees that are due first, then interest, with the remaining amount going toward the principal. As the principal decreases, the amount of interest that accrues can decrease as well.
6. The Car Secures the Loan
Auto loans are generally secured loans. The lender has a lien or security interest in the vehicle.
If you fail to make your payments, the lender may have the legal right to repossess the vehicle, depending on the loan agreement and applicable state law.
7. Your Loan-to-Value Ratio Matters
Loan-to-value, or LTV, compares the amount you’re borrowing with the vehicle’s value.
For example, if a car is worth $20,000 and you borrow $15,000:
$15,000 ÷ $20,000 × 100 = 75% LTV
A larger down payment can reduce the LTV because you’re borrowing less. A high LTV can increase the risk of owing more on the loan than the vehicle is worth.
8. Compare Loans Before Signing
Don’t focus only on the monthly payment.
Before signing an auto-loan contract, compare:
- APR
- Interest rate
- Amount financed
- Loan term
- Monthly payment
- Finance charges
- Total of payments
- Down payment
- Additional fees
Federal Truth in Lending requirements provide borrowers with important information about the cost and terms of the loan before they become legally obligated.
Final Answer
Auto loans work by allowing you to borrow money to purchase a vehicle and repay that money, plus interest and applicable costs, through scheduled payments. Your credit, income, down payment, interest rate, loan amount, and repayment term all affect the cost of the loan. Comparing multiple lenders and looking at the APR and total cost—not just the monthly payment—can help you understand the full cost before signing the agreement.