How do auto loans work?
Getting a new car can be an exciting adventure, driven by the question: “What should I get?” It can also be a major purchase, leading to the follow up: “What can I afford?” At the intersection of these two questions sits the auto loan.
What is an auto loan?
At its most basic, an auto loan is a form of credit. You borrow money from a lender to use toward the intended purchase — in this case, buying a car — to be paid back, plus interest, over time. As you research auto loans further, you’ll likely come across several terms you may not be familiar with:
- Principal: The amount of money borrowed.
- Interest rate: The cost of borrowing money, typically expressed as a percentage on the principal.
- Annual percentage rate (APR): APR is another percentage rate you’ll see associated with loans. Though it relates to interest rates, it’s not the same thing. APR takes interest into account, in addition to some other fees and costs associated with the loan and gives a more complete look at the cost of borrowing.
- Down payment: An upfront lump sum that goes toward the purchase price. The bigger the down payment, the less borrowed and therefore, the less owed on both principal and interest over time.
- Credit score: Put simply, a credit score is a number summarizing a borrower’s credit report and helps lenders assess the potential risk of lending money.
- Prequalification: Prequalification gives an idea of loan eligibility. Note that prequalification isn’t a guarantee of financing, nor does it replace the formal application process (though it may help speed it up).
- Lien: A lien is a legal claim that party X has over an asset of party Y, until Y fulfills their end of an agreement.
- Term: The length of a loan. This is the projected timeline for how long it takes to pay back a loan in its entirety
- Payment schedule: The schedule for loan repayment from day one of borrowing up until the balance hits zero. Loan payment schedules usually operate on a monthly basis.
What affects your monthly payment
The size of your monthly payment is affected by a variety of factors, including the borrowed amount, interest rate and loan term. While current rates and the amount you need to borrow may be outside your control, you may have flexibility in choosing your loan term. Shorter loan terms typically mean higher monthly payments and less interest expense, while longer loan terms typically mean lower monthly payments, though they tend to accrue more interest over time.
How to get an auto loan
If you’re ready to find out how to get an auto loan, follow this step-by-step process:
1. Check your credit score
Before you start, you may want to check your credit score since it’ll factor into what kind of loan terms you can get.
2. Get prequalified
Getting prequalified is an optional step, but it gives you an idea of what you can borrow. A prequalification tool can help you get started with just a few basic questions. While prequalification can provide a helpful borrowing estimate, it doesn’t guarantee financing.
3. Start shopping
Once you have a better idea of what you can qualify for, you can start shopping. Whether it’s online, in person, at a dealership or at a private sale, you can now look for a car you’ll love that can fit your budget.
4. Apply for financing
After finding a car, it’s time to officially apply for your auto loan. This can happen at the dealership, or you can apply online and show up at the dealership with financing in hand.
5. Get approved
Once your loan application is approved, it’s time to grab those car keys and drive off to your next adventure.
By understanding how auto loans work, you can be more informed during your next car purchase, from the time you start shopping until you drive off the lot.