How Do Car Loans Work? Understanding Interest Rates & Terms
- mbeasley682
- 2 days ago
- 4 min read
When buying a car, most people finance the purchase instead of paying with cash. If you are in the market for a new or used car, understanding car loan basics is essential for getting the best deal. It can help you save on interest and select a loan repayment term that fits your budget.
Whether you're a first-time car buyer or you're looking to upgrade to the latest model, we'll break down how car loans work in this auto financing guide. We'll cover interest rates, loan terms, and other information you'll need to choose a car loan that works for you.
How Do Car Loans Work?
A car loan is a special type of financing that is used to purchase a vehicle.
When you take out a car loan, you'll receive a lump sum for the full purchase price and then repay it over time with interest. Car loans are secured loans, which means the vehicle itself serves as collateral. If you stop making payments, the lender may repossess the vehicle to recover their money.
Car loans are typically obtained from banks, credit unions, dealerships, or online lenders. When you apply for vehicle financing, the lender will evaluate your credit score, income, employment history, and current debts to make sure you can repay the money you borrow. If you are approved, you'll make fixed monthly payments on the loan until it’s repaid. You'll repay the principal (the amount you borrowed) and interest.
How the Interest Rate Affects the Total Cost
Interest is the cost of borrowing money, and it's usually expressed as an annual percentage rate (APR). The APR is the yearly cost of the loan plus lending fees. For example, if your loan has a 6% APR, you'll pay 6% of the loan amount each year in interest and fees.
Car loans typically have fixed interest rates, which means your rate stays the same throughout the loan. Having a fixed rate means you'll know exactly what your monthly payments will be each month, which simplifies budgeting. You also won't have to worry about future rate increases.
The interest rate on your car loan has a big impact on how much you'll pay for your car over time. Even a difference of just one or two percentage points can cost or save you hundreds of dollars. That’s why it’s important to shop around and compare loans before applying for car financing.
To see how a small change in the interest rate can affect how much interest you’ll pay, consider a scenario where you are financing a $25,000 car with a 60-month loan. With a 5% interest rate, your monthly payments will be about $472, and you'll pay about $3,307 in interest over five years.
If your car loan interest rate is 9%, however, your monthly payments will be about $519, and you'll pay about $6,138 in interest over five years. That 4% difference in the interest rate might not seem like much, but it means you'll pay nearly $2,831 more for the same car, and your payments will be $47 higher each month.
Choosing the Right Loan Term
The loan term refers to the length of time you have to repay your car loan. Most auto loan terms range from 36 to 84 months. The loan term you select can affect how much interest you will pay over time.
Many people select shorter terms to pay their loans off faster and save on interest. The main drawback of a shorter term is that you will have higher monthly payments. Longer loan terms, on the other hand, allow you to stretch out the time it takes to repay your loan. Although this will result in lower monthly payments, you will pay more interest overall.
To see how different loan terms affect your payments and the interest you'll pay, consider a scenario where you are financing a $20,000 car at 6% interest. With a 36-month term, your monthly payments will be about $608, and you'll pay about $1,904 in total interest.
If you extend the same loan to 72 months, your monthly payments decrease to about $331, but you'll pay about $3,865 in total interest. The longer term saves you about $277 per month but costs you nearly $1,961 more overall.
How to Get the Best Deal on a Car Loan
Taking a few steps before you start shopping for a car can help you get a great deal on financing. First, be sure to check your credit score before you apply. If you have any credit issues, consider waiting a few months to improve your score. Increasing your score may help you qualify for a lower interest rate.
Making a larger down payment is another way to save on your car loan. By financing a smaller amount, you can reduce your monthly payments and potentially qualify for a shorter loan term. This not only helps you pay off the loan faster, but it also lowers the total interest you'll pay over time.
Getting pre-approved for a car loan can boost your negotiating power. It gives you an estimated loan amount and rate, helps you shop within budget, and positions you as a cash buyer to dealers, potentially leading to a better price.
Why Choose a Credit Union for Your Auto Loan?
Financing through a credit union is a smart way to get a great deal on a car loan. As nonprofit institutions, they focus on member value—not profits—often offering lower rates and fewer fees. Credit unions also provide flexible loan terms tailored to your financial situation.
You’ll benefit from personal service and local decision-making. Unlike big banks, credit unions consider individual circumstances and may work with those who have less-than-perfect credit. Loan decisions are fast, and you’ll likely work with the same person throughout the process.
Drive Away with a Great Rate Today
Understanding how car loans work puts you in the driver's seat when it comes to financing your next vehicle. By knowing how interest rates and loan terms affect your total cost, you can compare loans to choose the best option for your needs.
Ready to save on vehicle financing?
