How Do Car Loans Work and What Exactly Are They?

Looking for a new car to fulfill your dreams of traveling cross-country? Or maybe your old car has reached the end of its road? Can’t pay the full amount out of pocket? You’re not alone. In fact, more than 80% of all new car purchases are financed with a car loan.¹ The car loan process can get a little confusing with so many choices and terms out there.

If you’re looking to understand car loans — what they are, how they work, and more — you’ve come to the right place.

What’s a car loan?

A car loan is an installment loan used to purchase a new or used vehicle. After qualifying and being approved, a personal loan lender distributes 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 auto 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 are arranged 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. The dealer may be the original lender, in which case they typically sell the loan to a bank or finance company shortly after closing. Some car manufacturers have a financing arm, and new car dealerships may offer you a loan through the manufacturer.

What are the different parts of a car loan?

The components of a car loan help you decide whether the loan you’re looking at is the right fit for your pocket. Make sure to keep these four key elements in mind to know before committing:

1. 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, extended warranties or other charges from the sale.

2. 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 or 36-60 months.

3. 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 history and other factors.

4. 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.²

Can someone take over my car loan?

Now that you know a little more about car loans, you may be considering repayment and different ways to get back on track if you fall behind. One option might be having someone cosign your loan. If you have a cosigner and you fail to make payments, be aware that the responsibility would fall to your cosigner. There could also be an impact on the cosigner's credit.

If you find it challenging to keep up with your car payments, someone taking over your car loan might be a good solution, but isn’t always an option with every lender unless you have an assumable loan. An assumable loan is a financing agreement that allows a new borrower to take over the existing terms of a loan from the current holder. The new borrower will likely need to meet the lender's credit standards.³ A more promising solution could be refinancing your loan (which could lower your monthly payments by giving you more time to repay).

Is a lower monthly payment worth it?

While it may seem like a practical solution if you're budget-conscious, opting for a reduced monthly payment on a car loan also means taking a closer look at the long-term outlook. While a reduced monthly payment might provide you with immediate relief to cash flow, extending the loan term may significantly pump up the total cost of the loan over time.

Know before you buy

How you finance a car is a major decision. Equipped with the right information, you can feel more confident in how to go about it. If you still feel like you could use more insight before making a decision, check out our car purchase page for more information.

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Sources

1. Norrestad, F. Statista.com. (accessed October 12, 2021).
   
2. “How Much Should My Car Down Payment Be?” Nerdwallet.com. https://www.nerdwallet.com/article/loans/auto-loans/how-much-down-payment-make-buying-car (accessed April 22, 2024).
   
3. “Can Someone Take Over My Car Loan? Everything You Need to Know” Caranddriver.com. https://www.caranddriver.com/auto-loans/a43113216/car-loan-takeover/ (accessed April 22, 2024).

This article has been updated from its original posting in 2020 and 2021. Kim Gallagher contributed to this post.