According to Fortunly, over 85% of new vehicles in the U.S. are financed through loans.
But how do car loans work? What do you need to know as a borrower?
Join us as we take a closer look into car loans, breaking down the types, interest rates, approval processes, and more.
How Do Car Loans Work?
The car loan process begins with an application, which you’ll submit to a lender, whether that’s a bank, credit union, or dealership financing partner. In this application, you’ll provide details about your income, employment, and credit history.
Lenders assess this information to determine if you qualify and what interest rate they’ll offer you. Generally, a strong credit score, steady income, and low existing debt can help you secure a more favorable rate. The approval process varies depending on the lender, but most provide a decision within a few days.
Once you’ve been approved and the loan is active, monthly payments begin. Each monthly payment is split between the loan principal, which is the original borrowed amount, and the interest.
At the start of the loan term, more of your payment will go toward interest, with the balance shifting gradually toward principal as time passes. The structure, called amortization, means you pay off the loan more gradually at first, with the interest portion decreasing as the principal reduces.
Car loans come with fixed repayment structures, which means you’ll have the same monthly payment for the entire term. By understanding these basics, you can make an informed choice about the loan term that best fits your budget and financial goals.
Key Components of Car Loans
Let’s go into some more detail about the main elements involved. Car loans consist of several key components that influence the overall cost and terms of your loan. To make the right decision, it’s important to understand these elements:
- Interest Rates
- Loan Term
- Down Payment
Interest Rates
Car loan interest rates are a critical part of any car loan. They’re determined by several factors, including your credit score, the length of the loan term, and the type of lender.
Generally, a higher credit score helps secure a lower interest rate, making the loan more affordable in the long run. Lenders often offer lower rates for shorter terms because they carry less risk for them.
On the other hand, choosing a longer loan term may come with a slightly higher interest rate. It’s because lenders view longer terms as a higher risk, given the extended time to recoup the loan amount. A lower interest rate reduces the overall cost of the loan, so it’s worth comparing rates from multiple lenders to find the best option.
Loan Term
The loan term refers to the number of months over which you agree to repay the loan. Common terms range from 24 to 72 months, though some lenders may offer even longer options.
Shorter terms mean higher monthly payments, but the total interest paid will be lower. For example, a 36-month loan typically costs less overall than a 60-month loan.
Longer terms, however, spread out payments, making monthly installments more manageable. The flexibility allows borrowers to choose a term that fits their monthly budget, though it often means paying more in interest by the end of the loan.
Down Payment
The down payment is the amount you pay upfront when purchasing the car, and it directly reduces the amount you’ll finance. A larger down payment can lower your monthly payments and reduce the total interest you’ll pay over the life of the loan.
For example, a down payment of 20% or more can often lead to more favorable loan terms, as it reduces the lender’s risk. Even a small down payment, however, can make a difference in overall cost.
Borrowers with limited funds might consider saving for a larger down payment to secure better rates and lower their monthly financial commitment. A substantial down payment can also help prevent negative equity, where the car’s value is less than the loan balance.
Types of Car Financing Options
To find the best fit, it’s helpful to understand three common types of car financing options. These choices can affect interest rates, loan terms, and overall costs.
- Dealership Financing
- Bank and Credit Union Loans
- Online Lenders
Dealership Financing
Dealership financing is one of the most common choices for car buyers, largely due to its convenience. When you finance through a dealership, the application process is often fast and straightforward.
Dealerships may also offer promotions, like lower interest rates or rebates, especially on new models. However, convenience can sometimes come at a higher cost.
Dealership loans can carry higher interest rates than other options, particularly for buyers with lower credit scores. Although some dealerships work with multiple lenders, allowing you to compare offers, it’s still a good idea to review outside options to make sure you’re getting the best rate.
Bank and Credit Union Loans
Loans from banks and credit unions are another popular car financing choice. Traditional banks often provide stable and competitive rates, while credit unions sometimes offer even better terms, especially for their members.
Credit unions are known for their member-oriented service and lower fees, which can be beneficial for car buyers. These institutions might have more flexible lending criteria, making them accessible to a wider range of credit profiles.
To apply, you’ll need to contact the bank or credit union, either in person or online, and provide details on your finances. While this process may take a little longer than dealership financing, it can result in a lower interest rate.
Online Lenders
Online lenders have become a major player in car financing, known for quick approvals and competitive rates. Many online lenders cater to borrowers with a range of credit scores, offering options that sometimes beat traditional banks.
The application process is usually straightforward and can be completed from home, making it a convenient choice for tech-savvy buyers. Some online lenders even provide prequalification, allowing you to see your potential interest rate without impacting your credit score. But it’s important to verify the lender’s reputation, as online-only institutions vary in terms of customer service and support.
The Auto Loan Approval Process
Let’s take a more detailed look at the approval process. Understanding the auto loan approval process can help you prepare for what lenders look for when deciding to approve a loan.
The main parts of the approval process include:
- Credit Check
- Income Verification and Debt-to-Income Ratio
- Down Payment and Vehicle Details
Credit Check
The approval process begins with a credit check, where the lender reviews your credit history. It allows them to assess how you’ve managed credit in the past, including factors like timely payments and credit utilization.
A higher credit score shows lenders that you’re likely to repay the loan responsibly, while a lower score might signal higher risk. Lenders use your credit score to set the interest rate they’re willing to offer. People with higher scores often get more favorable rates, as lenders view them as lower-risk borrowers.
Income Verification and Debt-to-Income Ratio
Lenders also check your income to make sure you can handle the monthly loan payments comfortably. They may ask for recent pay stubs or other proof of income to verify this information.
Beyond just income, lenders also calculate your debt-to-income (DTI) ratio, which compares your monthly debt obligations to your gross monthly income. The ratio helps them gauge how much of your income is already committed to existing debts. A lower DTI ratio is generally seen as a positive factor in loan approval, as it suggests you have room in your budget for additional debt payments.
Down Payment and Vehicle Details
The down payment and the details of the vehicle you intend to purchase are the final parts of the approval process. A larger down payment can work in your favor by lowering the loan amount, making you a less risky borrower.
The car’s age, mileage, and value are also considered, as these factors affect its resale value. Newer vehicles are generally viewed more favorably by lenders, as they tend to hold their value longer, while older cars might limit loan options or come with stricter terms.
Choosing the Best Car Loans
Selecting the best car loan requires careful consideration of several key factors to ensure you get favorable terms. Here are three main points to consider when choosing the best car loans.
- Comparing Loan Offers
- Hidden Fees
- Reputable Lenders
Comparing Loan Offers
When choosing a car loan, it’s important to compare offers from different lenders to find the most favorable terms. Different lenders can have varying interest rates, fees, and terms based on factors like your credit score, loan amount, and length of the loan. It’s a good idea to request quotes from multiple sources, such as banks, credit unions, and online lenders, to understand your options.
Comparing the annual percentage rate (APR) on each loan is useful, as it reflects the total cost of borrowing, including any fees. A lower APR generally means a more affordable loan, so it’s worth spending time to find the best rate available to you.
Hidden Fees
Many car loans come with additional fees that might not be obvious upfront, but they can add to the loan’s overall cost. Common fees include origination fees, which some lenders charge for processing the loan, and early repayment penalties for paying off the loan before the term ends.
Reviewing the fine print can help you spot these hidden fees, allowing you to choose a loan without unexpected costs. Knowing about these fees in advance can also help you negotiate better terms or avoid lenders who include high fees in their loans. By understanding any extra charges, you’re better equipped to compare loans accurately.
Reputable Lenders
Selecting a reputable lender is as important as finding a good rate. A lender’s reputation can impact the quality of service you receive, especially if you need assistance during the loan period.
It’s helpful to research lenders by reading customer reviews and checking for any complaints or concerns, which can give insight into how the lender treats its borrowers. Reliable lenders often have a strong customer service track record and offer transparency in their terms, which can make the loan experience smoother. Working with a trusted lender provides peace of mind, knowing you’ll receive consistent and professional support throughout the loan term.
Refinancing a Car Loan
Refinancing makes the most sense if your financial situation has improved since you first took out your car loan. For instance, if your credit score has increased, you might qualify for a lower interest rate, which can reduce your monthly payments or the overall loan cost.
Similarly, if general interest rates have dropped, refinancing can help you take advantage of better terms.
Steps to Refinance
The refinancing process typically involves applying for a new loan to replace the existing one. First, you’ll want to check your credit score and compare offers from multiple lenders, including banks, credit unions, and online lenders, to find the best rate.
Once you’ve chosen a lender, you’ll submit an application, and if approved, the new lender will pay off the balance on your original loan. From that point on, you’ll make payments to the new lender under the terms of the refinanced loan.
Costs and Benefits
While refinancing can lead to lower monthly payments or reduced interest, it’s important to consider any fees. Some lenders charge fees for refinancing, and these should be factored in when calculating your overall savings. Reviewing these costs in comparison to potential interest savings helps you decide if refinancing is the right choice.
Understanding Car Finance
So now you have a much better sense of the answer to your question, “How do car loans work?” You can confidently choose a loan that fits your budget and financial goals, helping you navigate the car-buying process smoothly.
At Right Turn Auto Credit, we’re proud to be Canada’s leading choice in special financing, helping people secure car loans regardless of credit status. With over 12 years of experience, a 95% approval rate, and a “no judgment” approach, our team offers transparent, OMVIC-registered guidance to get customers driving at payments they can manage.
Get in touch today to find out how we can help with your car loan needs!
