Before you take out a car loan, it’s important to understand the basic terms of the loan, what you will pay in interest and whether the monthly payment is one you can afford. Any car loan you take out will cost you interest — that’s how lenders make money. If you can afford to save up and pay for your car in cash or set a little aside for a down payment, you’ll avoid losing money on interest.

The smartest car buyers know that cars quickly lose value, so there’s no point wasting a lot of money on interest payments over long periods of time.

What is a car loan?

A car loan is an agreement between a financial lender and a borrower where the lender gives the borrower money to purchase a car. The borrower promises to pay back the amount of the loan in monthly payments over a set period of time. In exchange for the loan, the lender charges interest that the borrower also has to pay on a monthly basis. 

Any time you purchase a car with a loan, you are immediately at a loss. The value of the car goes down the minute you drive it off the lot, yet you are still stuck paying the full amount of the loan and interest payments on it. 

What are the parts of a car loan?

When you’re considering a car loan, it’s important to know what these things are:

Interest rate and Annual Percentage Rate (APR)

An interest rate refers to the amount of interest charged on your loan balance.

The annual percentage rate (APR) is similar to your interest rate, but factors in any fees that the lender might charge you over the life of the loan. This could include document preparation fees, credit report fees and more. When you’re trying to figure out the total cost of a car loan, the APR is a more accurate figure than just the interest rate alone because either way, it’s an additional cost to you.

Down payment

A down payment is the amount of cash you pay at the time of purchase. It reduces the amount you need to borrow. Most experts recommend making a down payment of at least 20% of the total purchase price of the car.

The larger the down payment you make, the smaller loan you’ll need and the more you’ll end up saving in interest. If you can’t swing a large down payment, try to take a shorter loan term and make bigger monthly payments so you pay less in interest. 

If you can, wait to buy your car you want. Calculate what the monthly payment would be and instead put that money in a savings account every month until you have enough to pay for the car in cash. You’ll never lose money on interest that way, and might even earn a little interest in savings.

Loan terms

The loan term is the length of the loan. It’s usually expressed in the number of months it will take to pay off the loan. A car loan that has a term of 48 months will be paid off after 48 monthly payments.

When you are considering a loan, it’s important to know that the longer the term, the smaller the monthly payment. But, don’t be fooled into thinking this means you can buy a more expensive car. With a longer-term loan, you also end up paying more interest over the length of the loan — which is kind of like throwing money away. Instead, we recommend you stick with a less expensive car and the shortest possible loan term you can afford — no longer than 36 months. 

Principal

The principal is the amount of money that you’re borrowing. Figuring out the principal amount of the loan is fairly simple. Take the car’s total purchase price, add in any fees that are associated with the loan that you will have to cover and then subtract the down payment. That’s the initial loan principal. As you make payments, you’ll gradually pay the loan down and your principal will be a bit smaller each month until you’ve fully paid the loan off.

How much of a monthly payment can I afford?

Take a look at your income and expenses. You should keep your car-related expenses less than 10% of your pay before taxes and other things are taken out. That includes all car costs — insurance, gas, maintenance, parking, car payments, etc. If you make $3,000 each month before taxes, your car payment and expenses should be $300 or less.

Once you have a monthly budget in mind, figure out what total car purchase price you can afford to stay within that budget. Always spend less than the maximum amount you can afford. And be careful when estimating. If you over-estimate what you can afford you could get stuck with years of car payments that force you to reduce your other spending.

We recommend that you borrow as little as possible and buy a used car in good condition rather than a new car. Having a lower monthly loan payment will give you flexibility to save money and also spend on other things. 

If you remember that a car loan is debt and that you don’t want carry lot of debt — you’ll be less likely to get in over your head.

What will my monthly payment be?

After you have a monthly budget established, it’s time to find a car that will fit that budget. In order to estimate how much you might be spending on the actual cost of the car (not including the related costs like insurance and repairs), ask these questions:

• What is the purchase price of the car I want?

• How is my credit history?

• How much money am I putting down?

• Am I trading in an older car and how much is it worth?

All these things will affect your total monthly payment. If you have a poor credit history, your interest rate might be higher — so you might want to consider saving up cash to buy your car. If you put money down, your loan balance will be lower and you might be able to pick a shorter loan term. If you have a trade-in, the value of that car works like a down payment.

When you get into the actual car-buying process — visiting dealers, test-driving, looking at options — don’t get fooled into buying more features or a more expensive car.

When you get in the car-buying process, don’t get fooled into buying more features or a more expensive car. Stick to your budget.

This can be the biggest temptation in the car-buying process and also can cause you huge financial problems if you end up taking on more debt that you can pay back. Car sales people are trained to persuade you to increase what you buy — so you need to be strong and resist tempting options. Just remember, you’ve set your monthly budget and should stick to it.

What are the types of car loans?

There are two types of auto loans: direct loans and indirect loans.

Direct loan

A direct auto loan is where a bank or credit union gives the loan directly to a consumer — usually in the form of a check you take to the dealership with you. Many banks and credit unions give out auto loans to people who want to purchase vehicles.

It’s always a good idea to shop around at different lenders to try and get the best deal on interest before you settle on one.

Start with your own bank first then move on to other banks and credit unions. You already have a relationship with your bank so you might get a good deal. Credit unions have lower operating costs and, as a result, usually have lower interest rates. But often you have to be a member of that credit union to qualify.

Here are a few websites you can use to compare loans and loan rates:

• Bankrate: www.bankrate.com

• Lending Tree: www.lendingtree.com

Many times, a bank or credit union will pre-approve your loan and will give you a competitive interest rate for the purchase that is guaranteed for a set period of time, like 15 or 30 days. If you go into the dealership with a competitive pre-approval in hand, you can have more negotiating power.

If you are purchasing a used car from a private seller and aren’t paying cash, a bank or credit union will likely be the only place where you can get a loan for that car.

Indirect loan

An indirect auto loan is where a car dealership acts as an intermediary or third party between the bank or financial institution and the consumer. You apply for your loan through the car dealership but make payments to the lender.

If you go to a dealer and say you’re interested in buying a car, most likely they will ask you if you want to finance the car through the dealership. You can consider this option, but it’s a good idea to go into the deal having already compared other options and have a competitive pre-approval in hand. If you decide to finance your car through the dealership, they will handle everything when you go to buy the car.

As a general rule: Never go into the dealership without a clear budget and a plan or you might end up paying more than you need to or can afford. Also, try to negotiate the total price of the car separately from the terms of your loan — you don’t want to get caught negotiating both at once.

• See also: Buying a car

When you actually compare and choose a loan lender, you are looking for an option that will cost you the least in interest over time. Remember, cars immediately lose value when you drive them off the lot — so any interest you get stuck paying is above and beyond the value of the car.

Before you even step foot in a dealership, you should research car types and loan options that will fit your monthly budget. You can do this easily online with the following resources:

Car-buying guides:

• Kiplinger's Auto buying guide: www.kiplinger.com/guides/cars

• Consumer Reports Car buying advice: www.consumerreports.org/cro/cars/car-buying-advice/index.htm

• Edmunds: www.edmunds.com

Loan comparison sites:

• Bankrate: www.bankrate.com

• Lending Tree: www.lendingtree.com

When you start getting quotes from various lenders, ask them to give you quotes on the principal and APR on different loan terms. You’re looking for a good combination that fits your monthly budget and keeps your interest payments as low as possible in the long run. If you can afford a moderate monthly payment on a loan of five years, for example, see if you can get a cheaper car and pay that same monthly payment in three years — saving you two years’ worth of interest payments.

How are car loan interest rates determined?

Interest is a percentage of money you will have to pay on the loan principal — the amount that you borrow. Interest rates also are the way the lenders make their money.

Interest rates are determined by various factors such as:

Credit history

Your credit history is probably the biggest factor of how a lender determines your interest rate. Your credit history tells a lender a lot about your money habits and determines how risky it is to lend you money.

Age of the car

Used cars usually have higher rates than new cars, however, you’ll find exceptions to this rule at lenders such as credit unions. Some credit unions give you’re the same interest rate for new and used cars.

Length or term of the loan

Typically the shorter the loan, the lower the rate. However, the shorter the loan, the more money you’ll pay in monthly payments, but you’ll save money in the long run because you’ll pay less interest.

Geographic location

Location may be a factor in the rate you get. Some areas have higher interest rates than others and these rates do vary by region.

Whether you make a down payment

It’s also possible to get a lower APR by making a larger down payment at the time you purchase the car. This is something you should talk to your lenders about when you are comparing your auto loans.

Words to know

Unsure about something you read? Many of the financial terms you came across in this article are defined in our financial glossary. A-Z Glossary

Links we like

Here are a couple online features you might find useful:

• Bankrate: www.bankrate.com

• Edmunds: www.edmunds.com

• Carfax: www.carfax.com