When buying a new or used vehicle, paying the total cost in cash may not fit in everyone’s budget. Many people use a car loan to finance their purchase, but with so many options and terms out there, the process can be confusing.
Here’s some information to help explain what a car loan is, how it works and more:
What is a car loan?
A car loan is an installment loan used to purchase a new or used vehicle. The money comes from a lender, such as a bank or credit union, and is distributed in a lump sum to pay the dealership or private seller. The borrower (you) then repays the loan to the lender over a set period of time through monthly car payments, plus interest.
How do car loans work?
There are two main types of car loans: direct and indirect loans. Direct loans come from banks and other financial institutions and are taken out before you go car shopping. Getting the loan before you go car shopping can give you an advantage when negotiating a purchase price.
Indirect auto loans come straight through the dealer. After you find a vehicle you like, you fill out a loan application and give the dealership permission to run your credit. The dealership then takes that information and reaches out to lenders on your behalf to arrange a deal.
To learn more, check out our article on the difference between a direct auto loan and indirect auto financing.
What are the key components of a car loan?
There are four key components to every auto loan. Here’s a closer look to explain each one:
Vehicle price – This is the final price of the vehicle as listed in your purchase agreement. It may be higher than the sticker price if it includes taxes, fees or other charges from the sale.
Term length — The term length is the amount of time it takes to completely repay the car loan with interest. Common term lengths are 3-5 years and expressed in months (36-60 months).
Interest rate — Interest rates represent the amount of interest you pay until the auto loan is paid in full. Interest rates for car loans can vary widely, depending on your credit score and other factors.
Down payment — A down payment is the percentage of the vehicle price that is paid to the dealer up front. Down payments can be as low as 0%; however, 10% is recommended for a used car and 20% for a new car.1
What is auto loan refinancing?
Auto loan refinancing is when you replace an existing auto loan with a new loan with different terms. The goal of refinancing a car loan is to get an interest rate and/or monthly payments that are lower than your current loan. You may be able to refinance your loan with your original lender, but other financial institutions such as banks, credit unions and personal loan companies offer auto loan refinancing as well.
Some lenders also offer cash-out refinance loans, which is essentially an auto refinance loan combined with a personal loan. A portion of the funds is used to pay off the original auto loan, while the rest of the money can be used for other purposes like home improvements or medical costs.
When is a good time to refinance a car loan?
Not all situations are the same, but there are two common scenarios when refinancing a car loan can be the right call:
When the new loan terms offer a lower interest rate without extending the length of the repayment period
If your credit score has improved since the original purchase
It’s also important to note that the sooner you refinance a car, the better. When an auto loan is new, the majority of your first car payments typically go toward interest, not your principal balance. If you’re one or two years into a loan, you may have already paid off most of the interest so refinancing might not be the best decision. For more information, consider these pros and cons of refinancing an auto loan.
Know before you buy
Financing a car is a major financial decision. Now that you understand how an auto loan works, you can shop for your next car, and car loan, with more confidence.
1. Palermo, Nick. “What's the Right Down Payment on a Car Loan or Lease?” Autotrader.com. https://www.autotrader.com/car-shopping/whats-right-down-payment-car-loan-or-lease-212702 (accessed December 30, 2019).
