How Do Car Loans Work?
August 12, 2025 • 5 mins
Article Contents
Buying a new or used car is a big expense. Most people don’t have enough cash on hand to pay the full price upfront. With an auto loan, you don’t need to.
When you take out a car loan, you borrow money from a lender such as a bank, a credit union or an auto dealership. Your lender pays for the car in full (minus your down payment, if you made one). Then you make monthly payments to your lender to repay the loan over time.
In most cases, your car is collateral for the loan. That means if you stop making payments or otherwise violate your contract, your lender can repossess your car.
It’s a good idea to get pre-approved for a loan before you go car shopping. That way, you’ll know how much you can afford. Being pre-approved may also give more negotiating power with the dealership or a private seller.
Financing terms you need to know
Get familiar with these terms before taking out a car loan:
- Down payment – an upfront payment that you make toward the purchase of a car. If you can, it’s best to make a down payment equal to 20% of the vehicle’s purchase price. When you make a down payment, you can take out a smaller car loan, which lowers your monthly payments.
- Principal – the amount of money you’re borrowing to buy the car, not including interest and fees.
- Interest rate – a fee your lender charges you for borrowing money. The interest rate is usually shown as a percentage of the loan amount. The lower the interest rate, the less you’ll pay for the loan. Different lenders offer different interest rates, so it pays to shop around.
- APR (annual percentage rate) – your loan’s interest rate plus other charges such as fees. Generally, borrowers who have higher credit scores get a lower APR. The APR gives you a full picture of the cost to repay your auto loan. So when comparing loan offers, pay attention to the APR.
- Loan term – the amount of time you’ll have to pay off your loan. Some common loan lengths are 24, 36, 48, 60 or 72 months. With a longer loan term, your monthly payments will be lower, but the interest adds up, so you’ll likely end up paying more for the car.
- Monthly payment – the amount you pay to your lender every month. Your monthly payment includes the principal, interest and any fees.
Explain the factors that determine your loan terms.
Lenders consider several factors when deciding whether to offer you a car loan and which terms to offer.
Your credit score, which offers a peek into how you manage debt, is one of the most important factors. You’ll get a lower interest rate if your credit score is at least 661, according to Experian. Want to bump your number up before buying a car? Learn how to improve your credit score. If your credit score is low, another option is to apply for a loan with a co-signer or co-borrower.
A lender wants to make sure you’ll be able to make your monthly payments, so they’ll also ask for your income. Lenders are especially interested in your debt-to-income (DTI) ratio. This ratio tells them how much of your pre-tax monthly income is already being used to pay other debts. Your DTI helps a lender decide whether you’re a good risk for a car loan and, if so, helps determine the loan’s APR.
Your down payment amount is also considered. If you make a higher down payment, you’ll need to borrow less money, which means you’re less of a risk to lenders. That usually translates to a lower interest rate on your car loan.
The type of vehicle you buy also impacts your car loan. If you buy a new car, for example, your interest rate will generally be lower than if you’d purchased a used vehicle.
Another factor is your loan term. Your lender will offer various options such as 36-, 48-, 60- and 72-month loans. You can lower your monthly payment by choosing a longer loan, but you’ll pay a higher interest rate.
When applying for a loan, your lender can share how these factors will impact your monthly payment, as well as how much you’ll pay for the car over time.
Did you know?
The average car payment is $734 for a new car and $525 for a used car, according to Experian.
What goes into determining your monthly car payment?
Your lender calculates your monthly car payment based on the amount of money you borrowed, the loan term and the interest you need to pay. Fortunately, there are steps you can take to lower your monthly car payments.
Review your credit score. If you have a good credit score, you’ll qualify for a lower interest rate, which lowers your car payments.
Make a down payment. If you make a down payment on your vehicle — 20% of the purchase price is ideal — you can take out a smaller car loan. The smaller the loan, the lower your monthly car payments will be.
Trade in your current car. Offering a trade-in is another way to lower the price tag on your new vehicle, thereby lowering your monthly payments.
Choose a shorter term loan. If you have some wiggle room in your monthly budget, consider getting a car loan with a shorter term. While your car payments will be bigger, your interest rate will be lower with a shorter loan, so you’ll pay less for the car overall.
If you bought a $35,000 car with 20% down and typical interest rates:
- A 48-month loan at 3.87% APR would make your monthly payment $630, and will cost $41,520 over the life of the loan.
- A 60-month loan at 5.04% APR will have a monthly payment of $528, and will cost $42,987 over the life of the loan.
- An 84-month loan at 9.07% APR has a $451 monthly car payment, and will cost $49,178 total.
(The above examples assume $2,800 for title and registration fees. Your own interest rate will vary, based on factors like your credit score.)
If you’re buying a used car, your loan may be smaller than for a new car, but keep in mind that the APR for a used vehicle will probably be higher.
When applying for a car loan, don’t be shy about asking your lender questions. Make sure you understand your monthly payment, the length of your loan, and the loan’s rules. Some lenders charge a penalty if you pay your loan off early, for example.
Once you’re clear on the details of your loan, sign the paperwork and get ready to enjoy your new ride!
Sources:
Experian, “The Best Way to Finance a Car,” December 12, 2024.
CreditKarma, “How do car loans work?” August 15, 2023.
Car and Driver, “How Does Financing a Car Work?” January 17, 2023.
Kelley Blue Book, “How Much Is the Typical Car Down Payment?” March 21, 2025.
Experian, “APR vs. Interest Rate: What’s the Difference?” accessed June 3, 2025.
Experian, “What Is a Hard Inquiry and How Does It Affect Credit?” November 8, 2024.
Kelley Blue Book, “Do I Need Car Insurance Before Buying a Vehicle?” March 4, 2025.
Experian, “Average Car Payment in 2024,” October 28, 2024.
Consumer Financial Protection Bureau, “How does a lender decide what interest rate to offer me on an auto loan?” January 30, 2024.
Consumer Financial Protection Bureau, “What things can I negotiate when shopping for a car or auto loan?” August 28, 2023.
Consumer Financial Protection Bureau, “What is loan-to-value ratio in an auto loan?” March 7, 2024.
Experian, “What Is a High Interest Rate for a Car Loan?” October 16, 2024.
This article was created in accordance with the Patelco editorial policy.
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