What Are Car Loans and How Do They Work?

The average price of a new car in April 2023 was more than $48,000, according to Kelley Blue Book. If you’re shopping for a new or used car for the first time, there’s a good chance you’ll need an auto loan. That’s why it’s important to learn about car loans so you can find a loan with the best terms to meet your needs. Here are some important details about car loans.

What is a car loan?

A car loan is money you borrow, either from a lender or a vehicle dealer, to pay for a car that you otherwise can’t afford. The loan money does not go to you. It is paid to the dealer or private seller who is selling the vehicle to you. In exchange for the auto loan, you agree to pay back the original amount borrowed, plus interest and applicable fees. To take out an auto loan, you will have to sign a financing contract, which will include many loan-related terms, including:

• Annual percentage rate (APR) — This is the amount you’ll pay to borrow the money, including interest and fees, given as a yearly percentage. The higher the APR, the more you’ll owe in return for the loan. So, shop around and look for the lowest APR.
• Loan term (or loan duration) — This is how long you’ll have to pay off your loan. The longer your loan term, the more you’ll pay in interest.
• Down payment — This is an upfront cash payment you make toward the cost of the car. You can also trade in your vehicle and use the value of that vehicle as your down payment. The down payment helps lower the overall amount you need to finance — which can mean lower monthly payments and less interest paid over the life of the loan.
• Monthly payment — This is the amount you owe each month, and it includes principal, interest and other fees, if applicable.
• Principal — This is the original amount that you borrow, excluding fees, penalties, interest and other costs.
• Total cost — Total cost refers to the total loan amount, or overall principal and interest, you’ll pay over the life of your car loan.

View more auto loan terminology from the Consumer Financial Protection Bureau.

How do car loans work?

When you take out a loan, you agree to pay the money back to the lender in monthly loan payments. The monthly payment amount will primarily depend on the APR, the principal (or loan amount), and the loan term. Your lender may offer several ways to make your loan payment, including:

• Automatic payments from a checking or savings account
• One-time online payment
• Payment by phone
• Payment by mail
• Payment in person

Check with your lender to find out your monthly payment options.

How do I apply for a car loan?

You must complete a loan application that provides information about your financial situation. You may need to provide the following information on your application:

• Social Security number
• Sources of income
• Current and past addresses
• Current and past employment details
• Information about your debts

The lender’s approval process may start with a prequalification. During this stage, the lender may do a “soft pull” of your credit, meaning it won’t affect your credit scores. If you’re preapproved and move forward with a full application, the lender will likely pull a hard inquiry on your credit, which may cause a dip in your credit score. For more information, read Experian’s explanation about how loan inquiries may affect your credit score.

Who issues car loans?

Car loans are issued by direct lenders such as credit unions, banks, and online lenders, and also by vehicle dealers.

Should I get my car loan from a direct lender or a vehicle dealer?

That’s a great question, and the answer is “It depends.” You should compare loan offers from credit unions, banks, online lenders and your vehicle dealer to find the best deal.

At Affinity, we make the auto loan process easy with competitive rates as low as 6.89% APR¹ and a variety of loan terms to choose from. There are no application fees or prepayment penalties, and we'll even give you a 0.25% APR¹ rate discount for setting up automatic payments. Learn more about Affinity auto loan options.

My goal should be to get the lowest monthly payment, right?

Not necessarily. A lower monthly payment sounds good, but it’s important to understand the relationship between the loan term (length of the loan) and the interest you’ll pay over the life of the loan. Some borrowers prefer longer term loans up to 60 or 72 months because they’ll have a lower monthly payment, but there’s a catch.

With these longer loans, borrowers will pay more interest and an overall higher price for the vehicle because of the extra payments. You may end up owing more than the car is worth, known as being “upside down” on your loan.

Review our loan calculator information to see how the loan term and other factors – such as APR and down payment – can affect your monthly payment.

What if my credit score isn’t the greatest, or I’m on a tight budget?

You should always check your credit score and take a close look at your monthly budget to see if you can afford to make a monthly car payment. If your credit isn’t great, you may want to consider applying with a co-signer or researching lenders that work with low-credit borrowers.

Here’s some advice from NerdWallet on how to buy a cheap, drivable used car.

Should I get an extended warranty for my car?

New vehicles are covered by the manufacturer’s warranty, so you should only consider an extended warranty if you’re buying a used car. Whether you need one depends on many factors, including:

• Is the used car still covered by the original manufacturer’s warranty? (This could be the case depending on the age and milage of the used vehicle.)
• Does the make and model of your car have a great record for reliability?
• Will the amount of warranty coverage you receive be worth the price?

Learn more about extended warranties.

Do I have to pay sales tax on the car?

Currently, the states of Alabama, Delaware, Montana, New Hampshire and Oregon do not assess a vehicle sales tax. Buyers in those states may be in the clear. For everyone else, they may have to pay sales tax, and here’s a list of each state’s vehicle sales tax.

¹ APR = Annual Percentage Rate. Rate is effective as of 06/12/2023. Advertised rate includes 0.25% reduction off the standard interest rate for setting up automatic payments from your Affinity account. The rate without automatic payments will be higher. Other rates and terms available.