How Do Car Loans Work?

Dayton Uttinger  | 

You might be lucky enough to live in a city with great public transportation, but for most of the country, having a car is an essential part of modern living. However, most people don’t just have thousands of dollars sitting around, waiting to be spent. Instead, you’ve got to get a loan to finance a car purchase. But before you sign away a few hundred dollars every month, you should understand exactly what you’re getting into.

What is a Car Loan?

A car loan is a type of personal loan that you take out in order to purchase a car. Generally, you reach an agreement based on the down payment and your creditworthiness. You can reach this agreement with your bank beforehand, or a dealership can act as an intermediary for you.

In exchange for the loan, you agree to pay back a certain amount every month, based on the car’s worth and the APR (interest rate) that you agree to. Until you completely pay off the loan, which will likely take several years, the bank technically owns the vehicle and has a lien on it. An auto loan is actually a type of secured loan, meaning that the thing you are financing (in this case, your car) acts as security, or collateral, on the loan. Fail to make your monthly payments, and the lender can repossess the car to make up for the missing money. This doesn’t make auto loans a bad deal, it just means you need to make sure you can pay your lender on time every month.

What Do You Need to Take Out a Car Loan?

  • Proof of income
  • Proof of insurance; you can purchase this over the phone or fax at the dealership if need be
  • Proof of identity, most commonly your driver’s license
  • Some money for a down payment. The exact amount various; look below for exactly how much you should put down.
  • A good enough credit score

Is Your Credit Score High Enough for a Car Loan?

Ultimately, this depends on the size of the loan you’re trying to take on. You’ll likely be approved for a loan unless you have excessively bad credit— your interest rate will just be much higher. While someone with a great credit score can get an APR around 5 percent, someone with bad credit will get an APR closer to 20 percent. Many people wonder what a good APR is, but the truth is that the lower you can get it, the better. The higher your credit score is, the more likely you’ll get a lower APR. You can buy a car with bad or no credit, but be prepared to compromise in other areas.

How Much Money Should You Put Down on a Car?

Perhaps not surprisingly, this will also depend on the car you’re getting and how much you can afford. You should approach a car loan for a new Corvette differently than one for a clunker. If you can afford to, always put as much down as possible. If you can pay for the whole thing outright, this will save you a lot of money in the long term.

However, 20 percent of the car’s sticker price is often touted as an industry standard. You can get away with 10 percent, though, especially if the car is used. Used vehicles depreciate at a slower rate, so increasing the length or the amount of the loan won’t hurt your as badly. You should put as much as you can afford towards your down payment, but 10 percent should be your absolute minimum.

Should You Get Preapproved for a Car Loan?

Yes. Getting preapproved means going to the bank before you go to the dealerships and working out the terms of your loan there. This gives you the advantage in a couple of ways:

  • You already know that you’ve worked out the best loan you could possibly get.
  • It gives you time to consider exactly how to fit this loan into your budget.
  • You’re in a stronger negotiating position, since you’ve already worked out exactly how much you’re prepared to spend. Any salesman will have a hell of time swindling you when you’ve already worked out the numbers ahead of time.

A car is one of the biggest purchases that most people make in a lifetime. Although you’ll probably go through multiple cars, each car loan that you take out will be a different experience. It’s a delicate act to balance your monthly bill with your down payment. Be honest with yourself about your budget, and don’t reach too far. There’s a reason why not everyone drives a Lamborghini. Failing to make your monthly loan payments can end up wrecking your credit score, as well as leading to having your car repossessed.

Need to raise your credit score? Check out our tips and guides at the Fiscal Tiger credit score resource and learning center.

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Dayton is a chronic Wikipedia addict, which is detrimental to her social life but stellar for her writing. She resides in Boise, ID, surrounded by her own frantic outlines, highlighted encyclopedias, and potatoes. The latter was not by choice.