How Auto Loans Work
An auto loan is a secured loan used to purchase a vehicle, where the car itself serves as collateral. When you finance a car, the lender pays the dealer on your behalf, and you repay the lender through fixed monthly installments over an agreed-upon term. If you stop making payments, the lender has the legal right to repossess the vehicle to recover their money.
Auto loans are available from a variety of sources, including banks, credit unions, online lenders, and the dealership itself. Each source may offer different interest rates, terms, and conditions, so it is important to shop around before committing to a loan. Getting preapproved from your bank or credit union before visiting a dealership gives you a baseline offer to compare against dealer financing.
Most auto loans are installment loans with fixed interest rates, meaning your monthly payment stays the same for the entire loan term. The loan term typically ranges from 24 to 72 months, though some lenders offer terms as long as 84 months. While longer terms reduce your monthly payment, they increase the total amount of interest you pay over the life of the loan and raise the risk that you will owe more than the car is worth.
When you apply for an auto loan, lenders evaluate your credit score, income, employment history, and debt-to-income ratio to determine whether to approve you and what interest rate to offer. A higher credit score generally results in a lower interest rate, which can save you hundreds or even thousands of dollars over the term of the loan.
How Car Payments Are Calculated
Monthly car payments are calculated using the standard loan amortization formula. This formula determines a fixed monthly payment that covers both the interest charged by the lender and a portion of the loan principal, ensuring the loan is fully paid off by the end of the term.
M = P × [r(1+r)n] / [(1+r)n - 1] Where:
- M = Monthly payment
- P = Loan principal (vehicle price minus down payment and trade-in value)
- r = Monthly interest rate (annual rate divided by 12)
- n = Total number of monthly payments
For example, if you are purchasing a $35,000 vehicle with a $5,000 down payment and no trade-in, the loan amount is $30,000. At a 6.5% annual interest rate over 60 months, the monthly interest rate is 0.005417 (6.5% divided by 12), and you would make 60 payments. Plugging these numbers into the formula gives a monthly payment of approximately $587.
Your total cost includes the sum of all monthly payments plus your down payment and trade-in value. The total interest paid is the difference between the total of all monthly payments and the original loan amount. In the example above, you would pay approximately $5,220 in total interest over the 60-month term, bringing the total cost of the vehicle to roughly $40,220.
Understanding this formula helps you compare different loan scenarios before you set foot in a dealership. By adjusting the variables, you can see exactly how changes in the down payment, interest rate, or loan term affect what you pay each month and over the life of the loan.
New vs. Used Car Loans
There are meaningful differences between financing a new car and financing a used car, and understanding them can help you make a smarter financial decision.
New car loans generally come with lower interest rates because new vehicles are considered less risky for lenders. New cars have a known history, full manufacturer warranties, and higher initial values. Many automakers also offer promotional financing deals, including 0% APR for qualified buyers, as an incentive to move inventory. However, new cars depreciate rapidly, losing roughly 20% of their value in the first year and about 60% over the first five years.
Used car loans typically carry higher interest rates, often 1% to 3% more than new car loans. Lenders charge more because used vehicles have higher perceived risk due to unknown maintenance history, the absence of a warranty, and lower resale values. Despite the higher rate, the total amount financed on a used car is usually lower, which can result in lower monthly payments and less total interest paid.
Certified pre-owned (CPO) vehicles offer a middle ground. These are used cars that have passed a manufacturer inspection and come with an extended warranty. CPO vehicles may qualify for interest rates closer to new car rates while offering the depreciation savings of a used car.
When deciding between new and used, consider the total cost of ownership, not just the monthly payment. Factor in insurance costs, fuel efficiency, expected maintenance expenses, and how long you plan to keep the vehicle. A slightly older used car with a higher interest rate can still be the more affordable option overall if the purchase price is significantly lower.
Factors Affecting Your Auto Loan Rate
Your auto loan interest rate determines how much you pay to borrow money. Even a small difference in rate can add up to hundreds or thousands of dollars over the life of the loan. Several key factors influence the rate you are offered.
Credit score is the single most important factor. Borrowers with credit scores above 750 typically qualify for the best available rates, while those with scores below 600 may face rates two to three times higher. According to industry data, the average difference between a prime borrower and a subprime borrower can be 10 percentage points or more, which translates to thousands of dollars in additional interest on a typical car loan.
Loan term length plays a significant role as well. Shorter loan terms, such as 36 or 48 months, generally come with lower interest rates because the lender's money is at risk for a shorter period. Longer terms of 72 months or more often carry higher rates and increase the total interest paid substantially.
New versus used vehicle matters because lenders view new cars as less risky collateral. Used car loan rates are typically higher by one to two percentage points compared to new car rates for the same borrower and term length.
Down payment size influences your rate indirectly. A larger down payment reduces the loan-to-value ratio, which signals to the lender that you have a financial stake in the vehicle. This can result in a more favorable rate offer. A down payment of 20% or more is generally considered strong.
Lender type also affects your rate. Banks and credit unions often offer competitive rates, especially to existing customers or members. Dealership financing can be convenient but may carry a markup on the rate. Online lenders have become increasingly competitive and may offer lower overhead-driven rates.
Economic conditions set the baseline for auto loan rates. When the Federal Reserve raises or lowers its benchmark interest rate, auto loan rates tend to move in the same direction. Broader economic factors like inflation, consumer demand, and lender competition all influence the rates available in the market at any given time.
How to Get the Best Auto Loan
Securing the best possible auto loan requires preparation and comparison shopping. Following these steps can save you a significant amount of money.
- Check your credit before you shop. Review your credit report for errors and dispute any inaccuracies. Knowing your score before you walk into a dealership helps you set realistic expectations and identify whether you should spend time improving your credit before buying.
- Get preapproved from multiple lenders. Apply for preapproval from your bank, credit union, and at least one online lender before visiting the dealership. Multiple auto loan inquiries within a 14-day window are typically treated as a single inquiry on your credit report, so shopping around will not significantly impact your score. Having a preapproval gives you negotiating leverage at the dealership.
- Negotiate the vehicle price first. Always negotiate the purchase price of the vehicle before discussing financing. Dealers sometimes offer a lower price knowing they will make up the difference on financing terms. By separating the price negotiation from the financing conversation, you can ensure you are getting the best deal on both.
- Keep the loan term as short as you can afford. While 60 or 72-month loans have lower monthly payments, shorter terms save you money on interest and reduce the risk of being upside down on the loan. Aim for the shortest term that fits comfortably within your budget.
- Make the largest down payment you can. A larger down payment reduces the loan amount, lowers your monthly payment, decreases total interest, and provides an equity cushion that protects you from negative equity. Aim for at least 20% down if possible.
- Read the fine print carefully. Before signing, review the loan agreement for prepayment penalties, mandatory add-ons, extended warranty charges, and any fees that may have been bundled into the financing. Dealerships sometimes include products you did not explicitly agree to, so review every line item.
- Consider the total cost, not just the monthly payment. A common sales tactic is to focus on the monthly payment rather than the total loan cost. A lower monthly payment achieved by extending the term from 48 to 72 months can add thousands of dollars in interest. Always evaluate the total amount you will pay over the life of the loan.
Should You Make a Larger Down Payment?
Making a larger down payment on a car purchase has several important advantages, but it is not always the right choice for every buyer. Understanding the trade-offs helps you decide how much to put down.
The most direct benefit of a larger down payment is a lower loan amount, which means lower monthly payments and less total interest paid. For example, on a $35,000 vehicle at 6.5% over 60 months, increasing your down payment from $3,000 to $7,000 saves approximately $696 in total interest and reduces your monthly payment by about $78.
A larger down payment also reduces the risk of negative equity, commonly known as being "upside down" on the loan. This occurs when you owe more on the car than it is currently worth. Because cars depreciate quickly, especially in the first two years, a small down payment combined with a long loan term can easily put you in a negative equity position. If you need to sell or trade in the vehicle before the loan is paid off, negative equity means you would have to pay the difference out of pocket.
Additionally, a substantial down payment can help you qualify for a better interest rate. Lenders view borrowers who put more money down as less risky, which can translate to a lower rate offer and further savings over the life of the loan.
However, there are situations where a smaller down payment may make more sense. If you need to maintain an emergency fund, draining your savings for a larger down payment could leave you financially vulnerable. If you have higher-interest debt, such as credit card balances, it may be smarter to pay those off first and make a smaller car down payment. And if you qualify for a very low interest rate, such as 0% APR promotional financing, there is less financial incentive to put more money down since the cost of borrowing is minimal.
A general guideline is to aim for a down payment of at least 10% to 20% of the vehicle's purchase price. This strikes a balance between reducing your loan burden and preserving your cash reserves for other financial needs. If you can comfortably exceed 20% without compromising your emergency fund or other savings goals, doing so will save you money and provide greater financial flexibility throughout the loan term.
Frequently Asked Questions
How much car can I afford?
A widely recommended guideline is that your total monthly car expenses, including the loan payment, insurance, and fuel, should not exceed 15% to 20% of your monthly take-home pay. For example, if you bring home $5,000 per month, your total car costs should stay under $750 to $1,000. This ensures your vehicle does not consume too large a portion of your budget and leaves room for savings, housing costs, and other essentials. Use this calculator to test different price points and see what fits within your budget before visiting a dealership.
Is it better to finance through a bank or a dealership?
Both options have pros and cons. Banks and credit unions often offer lower interest rates, especially to existing customers or members, and the terms tend to be more transparent. Dealerships offer convenience since you can arrange financing on the spot, and they sometimes have access to manufacturer-subsidized promotional rates like 0% APR. The best approach is to get preapproved from your bank or credit union first, then see if the dealership can beat that rate. Having a preapproval in hand gives you leverage in the negotiation and a clear benchmark to compare against the dealer's offer.
What happens if I pay off my auto loan early?
Paying off an auto loan early can save you a significant amount in interest. Since interest on most auto loans is calculated on the remaining balance, paying it off sooner means the lender charges less interest overall. However, some lenders include a prepayment penalty in the loan agreement, which is a fee charged for paying off the loan before the scheduled end date. Before making extra payments or paying off the loan early, check your loan contract for prepayment penalty clauses. If there is no penalty, making additional principal payments each month is one of the most effective ways to reduce your total interest costs and free up your monthly budget sooner.
Should I lease or buy a car?
Leasing and buying serve different financial goals. Leasing typically offers lower monthly payments and allows you to drive a new car every few years, but you never build equity and face mileage restrictions and potential end-of-lease fees. Buying costs more per month but gives you ownership once the loan is paid off, and there are no restrictions on how you use the vehicle. If you drive a lot of miles, tend to keep cars for many years, or want to avoid perpetual monthly payments, buying is usually the better financial choice. If you prefer driving newer cars with the latest features and do not mind always having a payment, leasing may appeal to you, though the long-term cost is generally higher.