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What is a Car Loan and How Does It Work?

how does a car loan work

By Emily Delbridge. Car Insurance and Loans Expert

Emily Sue Delbridge has a strong family history in the insurance industry. She has been in the insurance business since 2005 with her primary focus on personal lines insurance. Read more

So you need a car now and you do not have the money now? If this is you, you are not alone. Welcome to the world of car loans. It can be overwhelming when you are first starting out. It is best to start with a good understanding of the basics. Understanding how a car loan works is the first step in getting a good deal on one.

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More specifically, a lender loans the borrower (you) the cash it takes to purchase a vehicle. In return the borrower agrees to pay back the lender the amount of the loan plus interest, usually in monthly payments, until the amount owed is fully paid off. Simple. So far.

Oftentimes, a personal loan is and unsecured loan. That is, the loan is made purely on the basis of the borrower's trustworthiness and not secured by some form of collateral. Car loans are different in that they are almost always secured loans whose collateral is the vehicle itself.

And that means that if the borrower fails to make his or her payments, the vehicle will be repossessed and sold to pay off the loan debt.

Elements of a Car Loan

Here are the basic building blocks of a typical auto loan:

  • Loan Cost: There are two basic parts to the cost of a car loan: the principal and the interest. The principal is the negotiated cost of the vehicle itself. The interest refers to the total amount of the costs accrued over the life of the loan based on the principal amount and the stated interest rate.

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  • Interest Rate. An interest rate is the basic rate charged to the borrower for the money loaned. The interest rate is normally expressed as a percentage for a one-year period and known as the annual percentage rate (APR).
  • Down Payment. The down payment is an upfront amount of cash paid by the borrower at the time of the purchase of the vehicle. It is usually expressed in terms of a percentage of the total price. It is not a legal requirement when taking out a car loan, but is almost always required by the lender.
  • Terms and Conditions. This refers to all of the other items that make up a car loan, including: the term of the loan, normally stated in a

    number of months or years; insurance and registration requirements; loan pay-off and resale terms; maintenance requirements; conditions regarding theft or accident; and conditions of loan default and repossession .  There are many, many others and a borrower is well advised to read them over carefully and have a clear understanding of what they mean before signing on.

The Car Loan Process

Here are a list of the steps you will likely follow in the process of securing a loan for your new vehicle:

  • Determine What You Can Afford: Get out a piece of paper and work out a realistic budget that tells you what you can afford in terms of a monthly payment. Then decide how long you are willing to have your loan last, i.e. the term of your loan. Next, determine the amount of the down payment you plan to make. The result will tell you how much car you can afford to buy.
  • Check Your Credit Score: It's important to know exactly where you stand in regard to your credit score before talking to lenders. Lenders rely on credit reports and scores when determining loan interest rates and terms. The higher your credit score, the better position you will be in to lock in a lower rate. 
  • Shop Around For The Best Loan Deal: This is important since rates and terms will vary, sometimes considerably, between lenders. It's also important to look for the best loan deal before heading out to shop for a car. Getting pre-approved for your loan means that you've set your limits before setting foot in a dealer's showroom where your emotions might get the best of you and your pocketbook. The best places to look for a pre-approved loan are banks and credit unions.
  • Shop for your car: Now it's time to visit your local auto dealers. 

A Few Car Loan Tips

Be sure to check on the reputation of your lender and read the fine print of the loan agreement before signing anything. And don't forget to check the math. Make sure that the numbers add up and match those that you and the lender agreed to. One more thing. Stay away from "conditional" or "contingent" loans. That's where you sign a loan agreement with a dealer and drive away with your new car before all of the terms of the loan have been finalized. Important items such as interest rate, loan period, down payment and the amount of the monthly payment may be changed (almost certainly to your disadvantage) and you could be stuck paying a lot more than you intended.

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