How do Car Loans Work

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If you’re in the market for a new vehicle, financing the purchase is one of the most common ways to do it. 

While it’s important to do a lot of research about the car you want to buy, it’s also important to understand your financing options and responsibilities. 

If you’re still in the researching phase, be sure to bookmark some of our helpful resources:

Auto Financing 101

First, you should understand that taking out a car loan means that you will be increasing the overall cost of the vehicle. 

You’ll be getting the money to pay for the car upfront, and you’ll be paying back that money plus interest over the period of your loan. 

The basic process for how car loans work is this:

  • You find a vehicle you want to buy. 
  • You decide to apply for financing for the purchase, which will factor in details such as: 
    • Your credit score. 
    • Your credit history. 
    • The type of vehicle. 
    • Your income. 
    • Your debt to income ratio. 
    • Your down payment. 
  • You’re offered loan terms to which you’ll need to agree.
  • You’re approved for the loan. 
  • You purchase the vehicle and get the keys. 
  • You start making your monthly payments.

Since taking out a loan is going to increase the overall cost of the car, it’s important to look at the full terms of your loan, not just the monthly payments. 

The monthly payment is affected by 3 main aspects of your loan:

  • The total loan amount, which is the amount you’ll be borrowing. 
  • The loan’s rate, which is the interest you’ll be paying on top of the principal amount. 
  • The loan’s term, which is how long you’ll be paying back the loan or how many monthly payments you’ll be making. 

You can start estimating your monthly payments with your car payment calculator

Key Car Loan Terms to Know

When selecting the right auto financing for your next vehicle purchase, you’ll be introduced to a number of different terms. 

All of them are important to understand because they’ll affect the total cost of your vehicle, how much you’ll be paying each month, and how long you’ll be making those payments. 

Check out some simple explanations of the key aspects to auto loans below. 


The car loan rate, or Annual Percentage Rate (APR), describes the cost of borrowing or the interest you’ll be paying on the loan. 

The interest is given as a yearly percentage rate, and a higher number means the more it costs to borrow. 

Down Payment

Your down payment is the money you’ll be paying up-front yourself. 

This could be cash or a trade-in value from your current vehicle. 

The down payment is going to lower the total amount you’ll need to borrow in order to purchase the vehicle. 

So, a higher down payment means a lower overall cost of the vehicle, and lower monthly payments over the term of your loan.  

Loan Amount/Principal

The principal is the amount you need to borrow in order to purchase the vehicle

You can think of it as the total purchase price of the vehicle minus your down payment. 

Car Loan Length/Term

The loan term, or loan duration, is how long you’ll have to pay off the loan

Loan terms are typically described in months, and are often offered in 12-month increments. 

A longer loan term may lower your monthly payment, but it will also usually raise your interest rate (APR) and the total cost of the vehicle. 

Monthly Payments

Your car loan monthly payment is the amount of money you’ll be sending to the lender each month over the duration of your loan term. 

The monthly payment includes a portion of the principal, interest, and any other fees and taxes that may apply to your loan. 

While getting the lowest monthly payment is often tempting, it’s important not to do so to a point where you’re paying much more than the vehicle is worth over the course of the loan. 

Total Cost of the Loan

The total cost of the loan describes: the principal amount plus the total interest you’ll be paying over the course of your loan’s duration. 

Your Credit Score

Your credit score and credit history are big factors in getting the best auto loan for your next vehicle purchase. 

This will directly affect the rates that will be available to you. 

A better credit score and credit history typically means that lenders will be able to offer you a lower rate. 

Next up: How to Finance a Car