Debt · February 24, 2022

How Do Car Loans Work?

It's easy to get caught up in the excitement of an offer of quick and easy financing when buying a new car. You may have been planning to put money down, but it's hard to resist when a dealer offers you a no-cash incentive and encourages you to drive away in a shiny new vehicle.

But before you set foot in a dealership, it's important to know the answers to these questions. How do car loans work? Do you know where to apply for a car loan? Where can you find the best deals? Once you have these answers, you'll feel better about signing on the dotted line.

How do car loans work?

A car loan helps you pay for the cost of a vehicle over time, with manageable payments that fit into your budget. Financing options include secured and unsecured loans.

  • Secured loans require collateral, which is typically the vehicle you purchase. This means if you miss payments on a secured loan, you could go into default, and the car may be repossessed by the loan grantor.
  • Unsecured loans don't require collateral. This type of financing option may include a personal loan that you qualify for based on your credit history.

No matter which type of loan you choose, lenders will take several factors into account when determining the annual percentage rate, or APR, which influences how much it'll cost you to borrow money. These factors include the amount you want to borrow, other outstanding debt and your repayment history. Instead of accepting a quick financing offer from a dealership, it may benefit you to shop around for lower interest rate options before completing your car purchase.

How to compare loan options

Evaluate car loans with a practical mindset, and try to set aside your excitement over the car itself. A loan payment calculator can show you how much total interest you'll be paying. Compare different loan terms to determine whether lower payments over a longer term make sense for you. A slightly lower rate on a longer loan—such as 5 years instead of 2 years—could mean you'll still end up paying more in interest, which effectively increases the price of the car.

Even if you're offered no money down, a small down payment can help you decrease the loan balance, which means you'll pay less interest. If you're offered a cash-back option, use a low-APR-versus-cash-back calculator to determine the difference between this type of loan and a traditional loan with no cash back but a lower APR.

Test drive your financing choices

If you go car shopping with the intention of just looking, you may feel unprepared to negotiate the best financing terms when the salesperson asks you to sign on the dotted line. Although you may be tempted to take advantage of the dealer's offer, take time to fully understand your options before accepting their financing terms.

Interest rates, APR, the down payment amount and length of the loan term impact how much you'll pay for a new car. These are important factors to consider before heading to the dealership, even if you're only planning to take a test drive.

Decide how you'll pay for a new—or new to you—car before encountering pressure from a salesperson. Don't say how much you'd like to pay per month. Instead, tell them how much you want to pay in total. To get this number, determine how much you want to finance and for how long as a way to pin down the loan that works best for you. Also look at financing options available for new, used and private car purchases.

Crunching the numbers ahead of time will put you in the driver's seat of any car-buying negotiations.

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