Sara Routhier, Managing Editor and Outreach Director, has professional experience as an educator, SEO specialist, and content marketer. She has over five years of experience in the insurance industry. As a researcher, data nerd, writer, and editor she strives to curate educational, enlightening articles that provide you with the must-know facts and best-kept secrets within the overwhelming world o...

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Joel Ohman is the CEO of a private equity-backed digital media company. He is a CERTIFIED FINANCIAL PLANNER™, author, angel investor, and serial entrepreneur who loves creating new things, whether books or businesses. He has also previously served as the founder and resident CFP® of a national insurance agency, Real Time Health Quotes. He also has an MBA from the University of South Florida. ...

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Reviewed by Joel Ohman
Founder, CFP®

UPDATED: Jun 30, 2021

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Summary

  • The longer you pay on auto loans, the more the interest rate affects the principal balance
  • You can secure a low annual percentage rate (APR) if you have exceptional or good credit
  • Defaulting on a secured auto loan may result in repossession of your vehicle

You’ve saved up enough money for a down payment, all you need now is an auto loan. But how do auto loans work? Before you get an auto loan, there are several things you should know.

Don’t worry — our guide has everything you need. Continue reading to learn how car loans work and how to secure a low interest rate.

When you’re done learning about how auto loans work, enter your ZIP code in the free comparison tool above to compare multiple lenders in your area.

How do auto loans work?

An auto loan is used to buy a new or pre-owned vehicle. You’ll need to visit a bank, credit union, or loan agency to get a loan.

The interest rate for the car loan depends on your credit score. In some cases, you can get a loan with a credit score of 550. However, it depends on the company.

Read on to learn about the elements of a car loan.

Factors of an Auto Loan

When pursuing a car loan, you’ll see a few terms as you shop around. Here are three factors of an auto loan.

  • Loan amount – The total amount of the loan you’ll need to repay
  • APR (Annual Percentage Rate) – Interest rate of the loan
  • Loan term – The time it takes to repay the loan in full

Your loan amount should be the cost of the car plus the estimated interest rate charges. The APR is the interest that’s added to your principal balance.

Finally, the loan term is the number of months or years it will take to pay off the loan.

Auto Loan Requirements

Before you get a loan, there are a few things you’ll need. Lenders ask for these items before moving forward with the loan process:

  • Permanent address
  • Employment history
  • Social Security number
  • Proof of income
  • Information on other debts

Lenders use this information as a financial background check to manage the risk of the borrower. Also, lenders can use this information to check your credit history.

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Types of Auto Loans

There are several types of car loans to choose from. Here are the four main types of auto loans that are available for borrowers.

  • Secured auto loan – A car loan that requires collateral to be attached to the loan
  • Unsecured auto loan – This loan doesn’t require any collateral but has a higher interest rate attached
  • Simple interest auto loan – You can pay extra money each month and pay off the car loan early
  • Precomputed auto loan – This car loan puts the borrower on a scheduled, fixed monthly payment, so paying extra won’t affect the total amount due

Financing varies for each loan agency. If you want to go through a bank, credit union, or finance company, you’ll use direct financing.

When the dealer selects the loan agency for you, that’s known as indirect financing. Indirect financing adds one percent to your APR.

Where can I get an auto loan?

You can get a car loan from a bank, credit union, or loan agency. Several finance companies provide auto loans online, also.

Before you commit to any loans, use an auto loan calculator to get an idea of how auto loans work.

Type “auto loan calculator” or “car loan calculator” in the Google search bar.

Put in a few numbers and percentages to see the estimated monthly payment of a car loan you’re considering. Your results will vary depending on the company you choose.

How do auto loans work from credit unions?

Credit unions are not-for-profit financial organizations. They’re smaller than banks. Therefore, credit unions focus more on customer service and company objectives.

A credit union may be more lenient if you have a fair or poor credit score. Explain your situation to the credit union, and you may get an interest rate that’s lower than you expected.

Will my credit score affect an auto loan?

The short answer is yes. According to the Federal Trade Commission (FTC), loan companies, banks, and credit unions give lower interest rates to borrowers with good credit.

Credit scores correlate to risk. If you have a poor credit score, companies consider you a high-risk borrower.

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Can auto loans affect auto insurance?

The answer is yes. Whether you’re getting a new or used vehicle, you’ll need to purchase full coverage car insurance.

Your lender wants to protect its asset as much as possible. Full coverage ensures that the vehicle is covered regardless of fault in an accident.

Take car insurance to the next level and add GAP insurance to your policy. With GAP insurance, you can cover the entire cost of the loan if the car is in a total loss accident.

Five Auto Loan Facts You Should Know

You’re almost there. Let’s review five facts you should know about car loans before you take the next step.

  • The cost of an auto loan depends on how much you borrow plus the interest rate
  • Delinquent or default auto loans could result in the repossession of your vehicle
  • Paying on a car loan improves your credit score
  • The longer you pay on an auto loan, the more interest you’ll pay
  • Some dealers have a buy-here-pay-here system, which allows you to pay at the dealership

Auto loans are designed just for vehicles. However, if you want to buy a fleet of cars, you may be eligible for a business loan. Weigh your options and compare multiple lenders for the best service.

How Do Auto Loans Work: The Bottom Line

Auto loans provide help with significant purchases. Buying a car is an investment, so you should shop around for the best interest rates regardless of your credit score.

Now that you know how auto loans work, use our free online quote tool to compare multiple lenders near you and secure the best interest rates.