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How do car loans work?

A car loan is a lump sum of money you borrow from a lender, like a bank or car dealership, so you can buy a car. You pay back the loan (plus interest) in monthly installments called loan payments.

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Rachael BrennanRachael BrennanSenior Editor & Licensed Auto Insurance ExpertRachael Brennan is a senior editor and a licensed auto insurance expert at Policygenius. Her work has also been featured in MoneyGeek, Clearsurance, Adweek, Boston Globe, The Ladders, and AutoInsurance.com.

Edited by

Anna SwartzAnna SwartzSenior Managing Editor & Auto Insurance ExpertAnna Swartz is a senior managing editor and auto insurance expert at Policygenius, where she oversees our car insurance coverage. Previously, she was a senior staff writer at Mic.com, as well as an associate writer at The Dodo.

Updated|6 min read

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Buying a car is no small decision. In fact, it can be one of the most significant purchases you’ll make. In addition to researching what make and model of car is right for you, you’ll also need to figure out how to pay for it. 

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While some drivers can afford to pay for a car up front, many people choose to finance their car, which means taking out an auto loan to buy their new or pre-owned vehicle, and then paying back the lender loan over time, with interest. Your lender then becomes your lienholder and must be included on your car insurance policy until the car loan is fully paid off.

Key takeaways

  • You can get a car loan directly from a financial institution, like a bank or a credit union, or through a car dealership.

  • Before getting an auto loan, figure out how much you can afford to pay up front, as well as how much you’ll need in total to buy the car you want.

  • If you have a car loan, your lienholder will be listed along with you on your car insurance policy.

  • Drivers who have a car loan may need additional types of car insurance, like gap coverage.

How do car loans work?

An auto loan works much the same way as other types of loans. You take out a car loan through an institution, like a bank, credit union, or the auto dealer where you’re getting the car. That institution agrees to loan you money to buy the car, and you agree to pay back the amount you borrowed through monthly loan payments, plus interest.

If you don’t keep up with your loan payments, the lender may take possession of your car. Remember, when you take out an auto loan, it means you’re not the only party with a stake in your vehicle — your lender also has a financial investment, and it’s important to know what that means for you.

Where to get a car loan

You have a few choices when looking for financing for a new or used car, so let’s talk about the most common options: 

1. Getting a car loan from a bank

You can get a car loan directly from a financial institution, like a bank or a credit union. Getting a loan through your bank means you get the money from them directly. This option might be especially appealing if you already have a relationship with your bank or credit union — that can sometimes help you secure a better rate. 

You’re also borrowing the money directly from that institution, instead of going through a middle man, which means you’re avoiding extra fees that might come with a third party auto loan.

2. Getting a car loan from a dealership

You can also get a loan through the auto dealership where you’re buying a new or used car. This scenario gives you the convenience of a one-stop-shop: You’re getting your car and loan in the same place, and you can usually complete the whole process in a day if speed is your first priority. And the dealership can give you offers from different lenders or other special deals, meaning you may have a few choices. 

But they’re not lending you the money directly, like a bank or a credit union. Instead, the dealership is the middleman, working with lenders to arrange a loan for you. The dealer will likely charge you more than the loan costs, because they’ll take a fee for arranging your loan, making the auto loan more expensive than a car loan directly through the bank.

What is a lienholder?

Whichever institution you choose to take a loan from will probably become your lienholder. A lienholder is just the party that owns your car loan. Often, this is the institution where you first borrowed the money, but your loan can be sold to another party, in which case they become your lienholder. 

If you’re not sure who your current lienholder is, you can find out by contacting your DMV to get your car’s title certificate, which is a legal document that says who owns a vehicle.

How much does a car loan cost?

The lifetime cost of an auto loan depends on a few different factors, but a car loan will usually wind up costing more over time than buying a car with cash. 

There’s the APR, which stands for the annual percentage rate. That’s the interest rate you’ll pay on the car loan. Interest is essentially the fee your lender charges for the loan, and the lower the APR, the less you’ll have to pay to them over time. 

Then there’s the down payment, which is the cash you put down at the outset of the loan. There’s also the loan term, which is the length of time you have to repay your auto loan, often between 36 and 72 months. 

Finally, there’s the principal, which is just the initial amount of the car loan. Over time, you’ll pay back the principal plus the interest you owe. All of those different factors will affect how much you’ll pay in interest on your loan.

How do car loan interest rates work?

A car loan with a lower interest rate but a longer term length may actually be more expensive over time than a loan with a higher interest rate but a shorter term, assuming you take the full loan term to pay them off. 

But the monthly payments for the auto loan with the shorter term may be more than your budget can handle. And increasing the down payment you put down can save you a lot in interest over the life of the loan.

Purchase Price

Down Payment

Interest Rate

Loan Term

Monthly Payment

Total interest Paid Over Time

Loan A

$20,000

$2,000

3%

48 months

$398

Loan B

$20,000

$2,000

4%

24 months

$782

Loan C

$20,000

$2,000

3%

36 months

$523

Loan D

$20,000

$5,000

3%

36 months

$436

Loan E

$20,000

$0

3%

36 months

$582

Loan F

$20,000

$3,000

5%

72 months

$274

Collapse table

How to save money on a car loan

Figuring out how to save on an auto loan can be tricky. As we explained above, an auto loan with a low monthly payment might look like a good option, but that can actually cost you significantly more over time. 

And the loans you’ll be offered will also vary depending on different factors, like your credit score — a poor credit history can make it harder to get the best auto loan offers. Here are things to look for and steps to take if you want to save money on your car loan.

  • Design a payment plan for yourself: Before you even submit a car loan application, set up a car payment plan for yourself. Figure out how much you can afford to pay upfront, and how much you’ll need in a car loan.

  • Shop around: This also applies to car buying and getting car insurance! You should always shop around to see your options before making a decision. You want to find a loan offer that fits your budget. And read the fine print carefully to make sure you’re comparing different car loans by the same metrics.

  • Make bigger or additional payments: Paying off a car loan early can save you money, because you’ll avoid paying some of the interest. See if you can afford to pay a little more each month as part of your regular payments, or, if you suddenly come into some extra cash, consider putting it towards your auto loan.

  • Refinance your loan: If you find a car loan with a lower interest rate than your current one, maybe because your credit score has improved since you first got your car loan, consider refinancing your car and switching loans. The lower the interest rate, the less you’ll pay over time.

How does a car loan affect your car insurance?

Taking out an auto loan to buy a car means that you’re not the only one with a stake in that vehicle. The lender also has a financial stake — at least until your car is fully paid off — and they’ll want to make sure their investment is protected. 

That usually means your lienholder will be listed along with you on your car insurance policy. Your lender may also require you to add certain types of coverage, like comprehensive and collision coverage, to your car insurance policy to protect their investment. 

What are comprehensive and collision coverage?

Comprehensive coverage covers damage to your vehicle that can happen while it’s not being driven, like damage from falling objects, fire, hail, wind, vandalism and theft. Collision coverage covers damage to your vehicle from an accident, no matter who was at fault.

Gap insurance

If you bought a new car with an auto loan, you might also want to look into adding gap coverage to your auto insurance policy.

If your new car is stolen or totaled, you won’t have it anymore — but your car loan will still exist. Your insurance will pay you back the actual cash value (ACV) of your car, but that may be less than you still owe on the loan.

Gap insurance will cover the “gap” between the ACV and what you owe, meaning you won’t be left making a payment on a car you don’t have anymore. Your lienholder may require you to have gap insurance, but even if they don’t, it can be a smart buy if you have an auto loan.

→ Learn about gap insurance for used cars

Filing a claim when you have a car loan

When you file a claim with your car insurance company and receive a settlement check, that check may be made out to both you and your lienholder. Remember, your lienholder is also listed on your car insurance policy.

Different lienholders will have different requirements, but your lender may require you to submit documentation proving that you are using the money on car repairs before they’ll endorse the check from the insurance company. Make sure to check with your lienholder about what they need from you before they’ll endorse a claims check, and be sure to save any and all documentation related to your car repairs.

Frequently asked questions

How does getting a loan for a car work?

When you get a car loan, a financial institution (either your bank or a lender affiliated with the car dealership) gives you a lump sum for the cost of your vehicle, minus your down payment. Then you’ll pay back the cost of the loan over time, plus interest. The amount of your loan, the length of you, and your interest rate all affect how much you pay for your loan over time.

Is a car loan a good idea?

Yes, for drivers who need a car and can’t afford to pay for one out-of-pocket, a car loan can be valuable and necessary. If the interest rate is low and you can afford the loan payments, there is nothing wrong with getting a car loan and paying off your car over time.

Is it better to get a car loan from a dealership or from your bank?

Both the dealership and your bank will offer you a loan, but you’ll likely get a better loan at a lower rate if you go through your bank.

Does an auto loan hurt your credit?

According to credit reporting company Experian, you might see a small dip in your credit rate when you take on a new loan. But making regular, on-time payments will help bring your credit rate back up.

Author

Rachael Brennan is a senior editor and a licensed auto insurance expert at Policygenius. Her work has also been featured in MoneyGeek, Clearsurance, Adweek, Boston Globe, The Ladders, and AutoInsurance.com.

Editor

Anna Swartz is a senior managing editor and auto insurance expert at Policygenius, where she oversees our car insurance coverage. Previously, she was a senior staff writer at Mic.com, as well as an associate writer at The Dodo.

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