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How Do Auto Loans Work?

How Do Car Loans Work? Auto Loan Basics
Sulaiman Abdur-Rahman
Sulaiman Abdur-RahmanUpdated November 13, 2024
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Editor’s note: Lantern by SoFi seeks to provide content that is objective, independent and accurate. Writers are separate from our business operation and do not receive direct compensation from advertisers or partners. Read more about our Editorial Guidelines and How We Make Money.
Buying a car is one of the biggest purchases you may make. And with average prices in the tens of thousands, it’s a financial move that often requires financing or a loan.Given high auto prices, it’s no surprise that people are borrowing more money than ever for their wheels — Americans have a combined $1.626 trillion in auto debt as of the second quarter of 2024. Indeed, borrowing money to cover the cost of a car is very common.Whether learning the generalities of what is an auto loan or the specifics of how bank car loans work, there is information that can help, as well as a few options to be aware of when it comes to financing a vehicle.

What Is a Car Loan?

Similar to other types of loans, getting a car loan means borrowing money from a lender, but specifically to cover the cost of buying a car.There are various options and lenders available when looking for an auto loan, such as financing from dealerships, banks, credit unions, and nonbank financial institutions.Recommended: What Type of Credit Is an Auto Loan?

How Auto Loans Work

Car loans function similarly to other types of loans in that the borrower agrees to repay the amount borrowed over time, as outlined in the loan agreement. The amount of money that needs to be repaid includes the principal, interest, and any applicable fees.One big difference between car loans and other types of loans is that borrowing money for a car almost always involves car loan collateral. While other loans may be either secured or unsecured, car loans typically are secured by the auto itself. In the event that the borrower can’t repay the loan, this leaves the lender with the ability to recoup that money via car repossession.Auto loans may feature simple interest charges that do not compound. Even so, with the average car loan length coming in just shy of six years, it’s worth noting that the longer the amortization period, the greater the interest charges will be, even if monthly payments are lower with longer loan terms.Loans with shorter terms under 60 months may feature lower interest on a car loan than loans with longer terms, further increasing potential car loan savings. This is because the longer the auto loan term, the riskier the lender deems it to be.

Key Auto Loan Terms to Know

Here are some common auto loan terms:
  • Annual Percentage Rate: The annual percentage rate, also known as APR, is the interest rate and fees a lender may charge when offering financing. Lenders must disclose the APR in nearly all consumer credit transactions under the Truth in Lending Act, so consumers generally have the ability to compare APRs on car loans.
  • Buyer: The buyer is the primary consumer who purchases the vehicle from a seller. The buyer may sign a buyer’s order when buying a new or used car.
  • Down Payment: A down payment is the amount of money a buyer may pay upfront to reduce total financing costs. One way consumers may avoid upside down auto loans is by making a sizable down payment when buying new or used vehicles.
  • Loan Term: The loan term is the total length of time that a borrower has to repay the debt in full. Auto loan terms are usually measured in months, such as 48 months, 60 months, 84 months, and even 144-month car financing.
  • Seller: The seller is the private person or car dealership selling you the vehicle. A private party auto loan can provide you with financing to buy a used vehicle from a private person selling a car.
  • Vehicle Identification Number: The vehicle identification number, also known as the VIN, is a unique serial number for a car. You may find the VIN on the driver’s side dashboard of a car.

What Types of Lenders Offer Car Loans?

Before a car buyer drives home with their new car, they’ll first have to obtain a loan if they plan to finance the purchase. This is commonly done through the car dealer, a bank, or a private lender. There are pros and cons to each option:

Banks

Qualifying for a bank car loan usually starts with a credit check. And as with other types of loans, an individual with a high credit score is more likely to be approved and may pay lower interest because they are considered to be at a lower risk of defaulting than an individual with a low credit score.Even if someone is concerned they don’t have the credit score needed to buy a car, it’s still worth applying, as a bank may allow a cosigner or offer a loan at a higher APR to account for the added risk. Many people can still get an auto loan with 650 credit score. However, if someone is concerned about their score, they may want to prequalify for a loan to get an idea of their chances minus the hit of a hard credit check.A bank will also likely want to see employment and income details, as well as a government-issued ID and proof of address. Some banks will also require information about the car the borrower wants to purchase.Some banks also offer car loan preapproval, which gives the borrower an idea of the amount of money they are eligible to borrow. This can be helpful information during car shopping because the buyer will have a better idea of their budget.

Dealerships

A car dealer has a vested interest in the car purchase. After all, if the prospective buyer needs financing but is unable to get a car loan, the dealer won’t make the sale and won’t get paid. Documents required to qualify for dealer financing are generally the same as those required for bank financing: proof of employment, income, and residence. Vehicle information will, of course, already be known.There are situations where this may work in the car buyer’s favor. For example, if the dealer has a lot of cars they need to sell or have been falling short of sales quotas, they may be inclined to reduce interest rates or offer low or 0% interest financing to incentivize buyers.Given that the average APR for a 60-month new car loan at commercial banks was 6.84% in the second quarter of 2024, the savings associated with such a promotion can be substantial. For a 60-month car loan to pay for an average-priced new car — $48,397 — the total paid over the term of the loan would be $57,280.16, including $8,883.16 in interest based on the average APR (not including any additional fees or taxes or accounting for a down payment).Dealers may also offer greater financing flexibility, which can be a double-edged sword. They may be more likely to extend a loan to someone whose credit score would disqualify them at the bank and might encourage a longer loan term to make monthly payments more affordable. But this may increase the risk of default for some individuals.

Private Lenders

Some car buyers might not want to use bank or dealer financing, but still need some sort of loan to buy a car. Financing through a private lender can be another option to consider.A private lender might be a friend or family member. If that’s not an option, peer-to-peer lending might be something to look into. P2P lending matches two individuals: one that has money to lend and one that needs a loan.People who might not have the creditworthiness to qualify for a loan from a bank or dealership might be able to qualify for a P2P loan, as they sometimes have more flexible qualification requirements. Shorter credit histories or credit scores that are just “fair” might qualify for a P2P loan, whereas those might be cause for denial of a traditional auto loan.

GAP Insurance Need to Knows

Guaranteed asset protection, also known as GAP insurance, is an optional coverage that car drivers may purchase. If you’ve taken out an auto loan, GAP insurance may benefit you in the event that your vehicle gets totaled or stolen.Standard auto insurance, including comprehensive coverage, may only insure the actual cash value of a damaged or stolen vehicle. This means the outstanding balance of your car loan may not be covered by your standard car insurance policy.GAP insurance, meanwhile, can help ensure that you won’t have to continue paying a monthly car payment on a destroyed or stolen vehicle. GAP insurance can fill the gap in situations where comprehensive coverage may fall short.

Personal Loans vs Auto Loans

Borrowers may use personal loans for almost any household purpose, while auto loans are restricted to financing the purchase of a motor vehicle. The below table compares personal loans vs. auto loans:
Personal loanAuto loan
Provides you with a lump sum of money and few restrictions on how you may use the fundsProvides you with financing exclusively for the purchase of a motor vehicle and no other purpose
Can have interest rates as high as 35.99%Can have interest rates as low as 0%
Typically unsecured without pledging any assets as collateral, but secured options may existTypically secured by the vehicle as collateral, but unsecured options may exist

Different Types of Auto Loans

Below we highlight several different auto loans:

Secured vs Unsecured Auto Loans

The difference between secured vs. unsecured auto loans is that the vehicle serves as collateral on the secured loan, whereas borrowers pledge no assets as collateral on an unsecured car loan.Lenders may seize the vehicle if a borrower defaults on the secured auto loan, which means secured auto loans present more risk to the borrower.Unsecured auto loans present more risk to the lender. The interest rate you get on an unsecured auto loan, therefore, may be higher than the interest rate you might get with secured auto loans. You may need good credit to qualify for an unsecured auto loan, and lenders may sue you for breach of contract if you fail to make required payments on the loan.

Simple vs Precomputed Interest Car Loans

A simple interest auto loan is a car loan that charges simple interest on the outstanding balance of your loan each month, while a precomputed interest car loan is a loan that calculates the finance charges up front and adds that to your principal loan balance from the outset.Simple interest loans may include a fixed APR, and monthly payments on the loan go toward interest charges and repaying the principal loan amount. Paying simple interest on the outstanding balance of your loan means the amount of interest you owe will decrease as you pay down the principal.With precomputed interest loans, the combined sum of your interest charges, principal loan amount, and any other finance charges represents your starting account balance. The lender would divide your starting account balance by the length of your term to calculate your monthly payment on the loan.You may be entitled to a refund if you pay off the precomputed interest car loan early. Prepaying a precomputed interest auto loan, however, is generally not as beneficial as prepaying a simple interest auto loan. That’s because any refund you get from prepaying a precomputed interest loan is generally lower than what you might have saved if the loan had a simple-interest cost structure.

Preapproved Auto Loans

Preapproved auto loans are a possible financing package you may get before visiting a dealership to buy a car. Banks, credit unions, and private lenders may offer these loans to creditworthy consumers.Getting a lender’s preapproval means the lender tells you how much financing it is willing to offer you and the proposed terms and conditions. A preapproved auto loan is conditional and not necessarily a guarantee of financing, but some lenders may give you a check equal to your preapproved amount.Going to a dealership with a preapproved auto loan means you don’t have to rely on the dealer for financing. A lender, however, may cancel your preapproved loan offer if you fail to meet its underwriting and qualification standards on the date of sale.

Other Special Loan Types

Other special loan types can include subprime auto loans for borrowers with bad credit scores below 600. Deep subprime borrowers had an average auto loan rate of 15.77% on new vehicle financing and 21.55% on used vehicle financing in Q2 2024. The average rate is generally much lower for borrowers with good credit scores above 660.Here’s additional loan types for car financing or refinancing:
  • No income verification car loans
  • Military refinance auto loan
  • 0% APR financing from captive finance companies affiliated with auto manufacturers

What Happens if an Auto Loan Is Not Paid Back?

Defaulting on any type of loan can negatively affect your credit score. Defaulting on a secured auto loan (or any secured loan, for that matter) means the lender can also initiate car repossession because the car was used as collateral.Talking to your lender when you realize you’re going to have trouble making your auto loan payments is a good first step to take. Some lenders might have debt relief options, such as skipping a few payments or refinancing the loan, for example.Some lenders might allow someone else to take over the payments on your loan. Having someone assume your loan typically requires similar documentation from that person as the original borrower provided when initially applying for the loan. The lender will want to make sure the new borrower will be able to make the payments.

Car Loan Requirements

Borrowers are generally expected to provide proof of identity and proof of income when applying for auto loan financing, among other requirements for a car loan.You may present a passport, driver’s license, or other documentation issued by a government agency as proof of identity.Pay stubs, bank statements, and W-2 tax forms may serve as proof of income. You may need the help of a cosigner to qualify for a car loan with no proof of income.

Can Someone Take Over a Car Loan if Someone Dies?

What happens to a car loan when the borrower dies? The answer is that car loans do not simply disappear when a borrower dies. A surviving spouse may be responsible for paying the debt, or a lender may move to repossess the vehicle. This shows it’s possible for a third party to take over a car loan if and when the main borrower dies.Taking over another person’s car loan doesn’t necessarily require a borrower’s death. If you’re drowning in car loan debt, you may wonder, “Can someone take over my car loan?” Transferring an auto loan can be a complex process, but it may be an option for you.

Car Loan Alternatives

Taking out a large loan to purchase a new car is not the only way to obtain a form of transportation. There are options to consider, such as:
  • Saving up to buy the car with cash
  • Save up a larger down payment so the amount financed is less
  • Buying an affordable used car rather than a new car
  • Leasing a car instead of buying a car
  • Using home equity to finance a car
  • Get a personal loan
Finding ways to make a car more affordable, regardless of financing, might be negotiating the price of the car, negotiating the trade-in value of the car you’re replacing (if that applies), or determining if any offered add-ons (such as extended warranty or service contract) are really worth the extra cost. Know what you are able to afford and don’t be afraid to walk away from a salesperson if you can’t come to an agreement.Recommended: 12 Questions to Ask When Buying a Used Car

The Takeaway

Whether you plan to use a car for weekends away and shopping trips or it’s a must for the daily commute, it’s likely to be a costly purchase. If a vehicle purchase is necessary, finding the best car for your circumstances at a cost you can afford is an important part of your financial plan.If you already have a car loan and are looking for auto refinancing options, Lantern by SoFi can help you compare rates and find the best option that works for your financial situation. Prequalification takes just minutes and checking auto refinance rates comes with no obligation to continue.Learn more about auto loan refinancing at Lantern by SoFi.

Frequently Asked Questions

Is getting a car loan in general a good idea?
Is it better to get car loans or bank loans?
Does a car loan amount include the down payment?
Do car loans go directly into your bank account?
Photo credit: iStock/Hispanolistic
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About the Author

Sulaiman Abdur-Rahman

Sulaiman Abdur-Rahman

Sulaiman Abdur-Rahman writes about personal loans, auto loans, student loans, and other personal finance topics for Lantern. He’s the recipient of more than 10 journalism awards and served as a New Jersey Society of Professional Journalists board member. An alumnus of the Philadelphia-based Temple University, Abdur-Rahman is a strong advocate of the First Amendment and freedom of speech.
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