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What is an Auto Loan – How It Works

Navigating the world of auto loans can feel like driving in the fog without headlights. But don't worry! We’re here to break things down so you can understand the journey ahead. By the end of this guide, you'll understand car loans, how they work and find the best loan option for you.

What is an Auto Loan?

Think of an auto loan as a helper. An auto loan can be used to purchase a new and used vehicle, including cars, motorcycles, commercial trucks, and even boats. Auto loans are usually offered as fixed-term loans with a low-interest rate, which is usually lower than other types of personal loans since the vehicle serves as collateral.

Key Terms to Know

In order to understand how car loans work, let's get familiar with some of the most common terms you might come across.

  • Annual percentage rate: APR is the amount you’ll pay to borrow the money, including interest and fees, given as a yearly percentage. The higher the APR, the more you’ll owe in return for the loan.
  • Principal: The initial amount borrowed to purchase the car. This doesn't include interest or additional fees.
  • Term: The duration of the loan, usually expressed in months (e.g., 36, 48, or 60 months). It indicates how long you have to repay the loan.
  • Down Payment: The upfront amount paid at the time of purchase. It reduces the principal amount that will be financed.
  • Upside Down: When you owe more on the loan than the current market value of the vehicle.

Auto Credit Express
  • APR: 5.18-21.32%
  • Loan Term: 12-72 months
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Carloans.com Brand Logo
  • APR: 3.2-24%
  • Loan Term: 12-84 months months
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  • APR: 4.67-23.80%
  • Loan Term: 24-84 months
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How Auto Loans Work

When you apply for a car loan, a lender checks your creditworthiness. The bank may lend you money to buy the vehicle you've always wanted if they think you can handle the responsibility. Car loans are repaid to the lender in monthly installments. Depending on the loan amount, loan term, and interest rate, your monthly payment will vary.

Your loan contract is broken down into the principal and interest on the loan, along with any optional add-ins. Loans with longer terms, such as 60-month or 72-month loans, can lower your monthly payment. When you add up the interest on a longer loan term, you might end up paying more over the life of the loan. In some cases, you may owe more than the car is worth, causing your loan to be upside down.

Types of Car Loans

There are a few common types of auto loans:

  • New car loans: Enable you to borrow money to buy a new car and pay it off over time. Lenders typically define a new car as one that has never been titled and is the current or previous model year.
  • Used or pre-owned car loans: Loans for used cars may come with certain restrictions, such as maximum mileage or vehicle age. These loans can help you pay for a used car you buy from a dealer, from an online car retailer, or from a private party.
  • Auto refinancing loans: Allows you to replace your current auto loan with a new one from another lender. Refinancing a car loan can be a way to lower your car payment or pay off your loan sooner, saving you money on the total paid interest.
  • Lease buyout loans: This type of loan enables you to finance the purchase of your leased vehicle, so you can keep it or sell it to profit from any equity you have in the car.
  • Motorcycle loans: Loans that you can use to buy a motorcycle. They can be secured or unsecured. Secured loans mean you put up your motorcycle as collateral.
  • Commercial truck loans: This type of loan helps businesses buy commercial vehicles, such as semi-trucks, for business purposes. This way, a company can obtain the vehicle they need as opposed to waiting until they have the cash on hand.
  • Boat loans: These are installment loans that may run from 2 to 7 years. When applied online, this type of loan is not backed by the boat to secure it. Therefore, it represents an unsecured lending product.
  • Cash-out auto refinance loans: Work like regular refinancing, but you can borrow extra money against the equity in your car and roll that amount into the refinance loan.

How To Apply 

  1. Review Your Credit Report: Before applying for a car loan, examine your credit reports from major bureaus like Equifax, Experian, and TransUnion at AnnualCreditReport.com. Ensure there are no errors, as these can lower your score. If discrepancies arise, dispute them; bureaus have 60 days to respond.
  2. Set Your Budget: Before securing a car loan, establish what you can afford using our car loan calculator to gauge monthly payments and loan duration. Decide between new cars, which are pricier but offer better financing and features, and used cars, which are more affordable and depreciate slower.
  3. Get Preapproved: Getting preapproval for a car loan clarifies your expected offer. Holding a preapproved loan can enhance negotiation leverage at dealerships, which sometimes mark up APRs for profit. Knowing your preapproved rate ensures you don't overspend and lets you challenge the dealer to offer a better rate.
  4. Select a Lender: Once you’ve compared multiple loan offers, it’s time to narrow it down to one lender.  Once you’ve found a potential lender, be sure to compare features such as down payments, interest rates, fees, terms, and borrowing limits. You may also want to ask about unique features, like financial hardship support.
  5. Finalize Your Car Loan: Once you pick a lender, review the auto financing contract and if everything looks ship-shape, you can finalize the agreement. This federal disclosure highlights your APR, total charges, borrowed amount, and payment details. Ensure you understand all terms, and question any unusual fees before signing. Once satisfied, sign the agreement. Congrats on your new car and loan!


Auto loans are one way to help you get closer to your dream vehicle. By understanding the basics, types, and application process, you can consider if it's the right path for you. Safe travels on your financial journey!