The Right Auto Loan Can Save You Money Amid Inflation and Soaring Car Prices. Here’s What to Know

A photo to accompany a story about how car loans work Getty Images; Hunter Newton/NextAdvisor
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Buying a car right now is both harder and more expensive than ever before.  

Car prices have spiked significantly in the past few years, due to factors including a global chip shortage that started during the COVID-19 pandemic, inflation, low inventory, and high demand. The average price for new vehicles rose 12.5% from March 2021 to March 2022, according to the April Consumer Price Index report from the U.S. Bureau of Labor Statistics. Meanwhile, the average price for used cars and trucks rose 35.3% during that same period. 

“If someone really needs a vehicle, prices are somewhat irrelevant,” says Jeffrey Roach, chief economist at LPL Financial, as he compared car shopping in the current market to the similar troubles homebuyers are facing

If you don’t have the luxury of waiting to buy a car, there’s not much you can do about the fundamental supply issues behind elevated car prices. Instead, you can focus your efforts on another way to save money — by finding the best car loan to finance your new vehicle.

“You’re shopping for two things — a car and financing,” says Matt Degen, editor at KBB.com, a vehicle valuation and automotive research company. “So, you want to shop around to get the best rate and terms you can.” 

But first, you’ll need to understand how auto loans work so you can shop empowered and streamline the auto financing process. 

What Is a Car Loan?

If you need to buy a car but can’t pay in cash, you can finance the purchase with a car loan, also known as an auto loan. Banks, credit unions, online lenders, and other financial institutions offer these loan products. 

Auto loans can be used to purchase a new or used car. If you’re approved for financing, the loan proceeds are paid to the car seller, and you will make equal monthly payments to the lender over a set period.

Key Terms to Know for Car Loans

It can be challenging to understand how car loans work without knowing the jargon commonly used by lenders. Here are the important terms to know before shopping for auto financing: 

  • Annual percentage rate (APR): How much it costs to borrow money. It’s commonly expressed as a yearly percentage and includes both the fees and interest rate.
  • Interest rate: The cost of borrowing expressed as a percentage, minus fees.
  • Principal: The amount you borrow from the lender to purchase the vehicle, minus interest and fees. 
  • Loan term: Also known as the repayment period, this refers to the amount of time you have to make monthly installment payments. Auto loans usually come with a 24, 36, 48, 60, 72, or 84-month term. Given the same loan principal and APY, a longer loan term usually means a lower monthly payment, since you’re spreading out the total loan amount over a longer period of time. However, you’ll also be in debt for longer and will pay more in interest. 
  • Taxes and fees: In addition to the purchase price of the vehicle, there are also state sales taxes, loan fees, dealer fees, and other costs associated with purchasing a vehicle. Depending on the lender, you may be able to roll these extra costs into your auto loan.
  • Down payment: The amount of money you pay upfront when purchasing a car. The larger your down payment, the less money you’ll need to borrow, which means your monthly payment will be smaller and you’ll pay less interest over the life of the loan. If you’re trading in a vehicle, the amount the dealer offers you for your trade-in is also factored into the down payment. 
  • Monthly payment: The sum of principal, interest, and fees (if applicable) you pay the lender each month. 
  • Amortization: This refers to how your monthly payment is allocated to both principal and interest over the duration of the loan. At the beginning of the loan, a larger percentage of your monthly payment will go toward accrued interest, with a smaller percentage going toward the principal. At the end of the loan, your monthly payment will primarily go toward principal instead of interest. 
  • Total cost: The total amount you pay for the car loan, including principal, interest, and fees. 
  • Prepayment penalty: A fee some lenders charge if you pay off your loan early, such as by making an extra lump sum payment or paying more than the required payment each month. If your loan has a prepayment penalty, it will be noted in the fine print of the contract. 

How Do Car Loans Work? 

Car loans are payable in monthly installments over the loan term. They’re a secured debt product, which means the lender holds the title to the car while you have the loan. In the unlikely event that you can’t make the loan payments, the lender can repossess the vehicle. 

When you buy a car from a dealer, the dealer may present you with a few financing options from its partner banks or from the dealer’s in-house financing department. You can also apply for your own financing from a private lender — such as your own bank or credit union — where you may be able to find better terms or lower rates. Regardless of where you apply for financing, a lender will typically look at your credit score, income, employment, and other debts you have when deciding whether to approve you for a loan and what interest rate to offer you. 

Pro Tip

Compare offers from multiple lenders to find the best rate. The best financing option may not be the one your dealership offers you.

In most instances, you’ll have the opportunity to choose between multiple loans with varying interest rates, loan terms, and monthly payments. Remember to compare rates from different lenders in order to find the best deal.

How Does Interest Work on a Car Loan? 

The interest rate is the cost of borrowing money, expressed as a percentage. When you repay your auto loan, you’ll pay back the principal in full, plus interest. Given the same principal balance and loan term, a higher interest rate will mean a higher monthly payment and more interest paid over the life of the loan.

To illustrate, here’s the monthly payment and total interest paid on a 48-month, $30,000 car loan with an interest rate of 8% and 5%:

8% Interest Rate5% Interest Rate
Monthly payment$732$691
Total interest paid$5,154$3,162

The lowest rates are generally reserved for well-qualified borrowers with good or excellent credit. But if your credit score is on the lower end, your cost of borrowing will likely be much higher. 

Before you start shopping for a car, you should check your credit score to get a sense of where you stand and what rates you might qualify for. If your credit history is less-than-perfect, you can take steps now to repair your credit using these strategies.

Like with a mortgage, you may be able to refinance an existing car loan down the line to secure a better rate, but don’t stake your plans on that possibility when you buy a car. Lenders may require you to meet certain requirements before you can refinance your loan, and if your credit score or the broader rate environment changes, you might not get a better rate at all.

How the Loan Term Affects Your Loan

The loan term also impacts your monthly payment and how much interest you’ll pay. An extended loan term could mean a lower monthly payment. However, your total cost for the vehicle will be higher since the lender will have more time to collect interest from you. Your loan term could also impact the interest rate you receive. 

For example, let’s assume you take out a $30,000 loan at a 5% interest rate. Here’s how the monthly payment and total interest would differ between a 60-month loan and a 48-month loan:

60-month term48-month term
Monthly payment$566$691
Total interest paid$3,968$3,162

How the Down Payment Impacts Your Loan

It’s possible to get approved for a car loan with no down payment, though this option is typically reserved for car buyers with good or excellent credit. The upside is you won’t have to pay any cash upfront to drive the car off the lot. However, the lender must agree to roll taxes, fees, and extended warranty costs (if applicable) into the loan balance.

Even if your lender doesn’t require a down payment, it’s still a good idea to have one. Putting money down means you’ll owe less, your monthly payments will be lower, and you’ll pay less in interest over the life of the loan. Some lenders may also offer you a better interest rate if you put money down, saving you even more money in the long term.

How Amortization Works on a Car Loan

Most auto loans are fully-amortizing, which means that the monthly payments are calculated so that if you make every payment according to the original loan schedule, the loan — both principal and interest — will be completely paid off by the end of the loan term.

At the beginning of the loan, a larger percentage of each of your monthly car payments will go toward interest. Your principal balance won’t decrease much until you’ve had the loan for some time. Over time, as you pay down the principal and less interest accrues as a result, a more significant portion of the monthly payment will go toward the principal balance. 

Since the value of a car depreciates as it ages, you could find yourself with negative equity in your car loan — also known as being “upside-down” — if you decide to get rid of the vehicle near the beginning of the loan term. This means you owe more than the car is worth, and it can be challenging to sell it or trade it in without having to pay out of pocket. Negative equity is more likely to be a problem if you didn’t put any money down when you purchased the car, or if you chose a longer loan duration. 

What Happens If You Pass Away? 

If you pass away before the loan is paid off and it goes into default, the lender could choose to repossess the car. “It is essential to let your family members or estate planning attorney know that your car is financed with an auto loan so that arrangements can be made to avoid defaulting on the loan in the case of death,” says Ryan Sellers, founding partner at Hales & Sellers, PLLC, a law firm that specializes in estate planning.

Where Should I Get My Car Loan?

When you’re ready to shop for a car loan, you have two main options: dealer financing or outside financing from your own bank, credit union, or an online lender. 

“At Kelley Blue Book, we recommend getting pre-approved from your bank or a credit union to give you options,” says Degen. “Getting preapproved gives you the ability to walk into the dealership and show you’re a serious buyer. It also gives the dealership a chance to beat [your offer].”

That’s not to say you’ll always get a better deal with outside financing. “There are reasons to get dealer financing. A lot of that is tied to incentives. Like everything else, compare your options with multiple lenders to determine where you’ll get the best deal,” Degen adds. 

If you’re unable to get approved for a traditional auto loan, consider getting a co-signer with excellent credit and a steady source of income. You could improve your chances of getting a car loan with favorable terms since the co-signer will be equally responsible for the debt. However, be aware that having a co-signer on a loan comes with certain risks for both parties involved.

Auto Loan vs. Personal Loan 

Unlike auto loans, which are secured loans specifically used for a car purchase, a personal loan is an unsecured loan that can be used for any purpose — including buying a car. 

However, personal loans tend to have higher interest rates than car loans, as the debt is unsecured and thus more risky for the lender. In most circumstances, you’ll likely be better off buying a car with an auto loan instead of a personal loan, unless the loan amount is very small or the car you want to purchase isn’t eligible for an auto loan. 

How to Apply for a Car Loan

  1. Check your credit score and credit report. “Better credit means better terms for your financing,” says Degen. “If you don’t have a good credit score, you’ll probably be paying a higher interest rate. If you have time to get your credit score up before buying a car, that is always a good thing,” he adds. You can check your credit report for free at AnnualCreditReport.com. While there’s no official source for accessing your credit score for free, many banks and credit card companies will show customers their credit scores in their accounts. 
  2. Shop around for financing with direct lenders. Start with your current bank or financial institution, as you may get special discounts or incentives for being an existing customer. You can also check out online auto loan lenders, which sometimes offer better deals than brick-and-mortar institutions. 
  3. Get pre-qualified for a loan. Narrow down your list of options and get pre-qualified. Many lenders offer online tools that allow you to view loan offers without a hard credit check, which means you can check your rate without damaging your credit score. It’s also a good idea to gather your most recent pay stubs or tax returns (if self-employed). The lender will need these documents at some point in the application process. 
  4. Run the numbers. Review your monthly budget to determine how much car you can afford. Aside from the car payment itself, be sure to factor in other costs associated with owning a vehicle, such as repairs and maintenance, fuel, car insurance, and annual registration renewal expenses. 
  5. Start car shopping. With a pre-approval in hand, you can begin your search for a vehicle that meets your needs and budget. When shopping around, only consider cars that meet the lender’s guidelines and are eligible for financing. “Try not to get so caught up just on the monthly payment, and don’t tell the car dealer what your budget is. It’s really tempting, but you should really focus on the overall cost of the loan and figure out the terms that will work for you. Know your own personal comfort zone and what you can spend,” Degen advises. 
  6. Compare your loan options. If you did your research beforehand, you should have several lenders to choose from besides the financing options your dealer offers. Now, choose the one that best suits your individual needs. “Make sure that the offers are as comparable as possible, including the number of months the loan is for, how much you will be paying as a down payment, and any other incentives or discounts offered,” Sellers advises. 
  7. Select the best offer and finalize your loan. Submit any additional information and documents the lender needs, receive your final approval, and sign the closing documents. 
  8. Get car insurance if you don’t already have it. Before you can drive your car off the lot, you’re legally required to provide proof of auto insurance. If you already have a policy in place, you can ask your insurance company for the documentation. If you’re a new car owner, be sure to shop around with multiple insurance providers to get the best rate.
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