How do car loans work?

And how does your auto loan affect your car insurance?

Anna Swartz 1600

Anna Swartz

Published April 3, 2019

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. 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.

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 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 payments, plus interest.

If you don’t keep up with your 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.

In this article:

Where to get a car loan

You have a few choices when looking for an auto loan, let’s talk about the most common options. First, you can get a loan directly from a financial institution, like a bank or a credit union. This option might be especially appealing if you already have a relationship with your bank or credit union — and 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.

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 number one priority. And the dealership can give you offers from different lenders, meaning you may have a few choices. Auto dealerships may also offer special deals to try to get you to take out a loan with them.

But they’re not lending you the money directly, like a bank or a credit union is. 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. That can make loans through a dealership more expensive than going through a bank or credit union directly.

Whichever institution you choose to take a loan from may 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. 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. There’s the down payment, which is the cash you put down at the outset

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. And then 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 over time.

All of those different factors will affect how much you’ll pay in interest over time. A 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 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 PriceDown PaymentInterest RateLoan TermMonthly PaymentTotal interest Paid Over Time
Loan A$20,000$2,0003%48 months$398$1,124
Loan B$20,000$2,0004%24 months$782$760
Loan C$20,000$2,0003%36 months$523$845
Loan D$20,000$5,0003%36 months$436$704
Loan E$20,000$03%36 months$582$938
Loan F$20,000$3,0005%72 months$274$2,712

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 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 out 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 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 in to some 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.

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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 to your policy to protect your shared investment (aka your car).

Many lienholders will require you to add comprehensive and collision coverage to your car insurance policy. Comprehensive coverage will cover 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 if they don’t, and you bought a brand new car with a loan, it can be a smart buy.

Filing a claim when you have a car loan

When you file a claim with your car insurance and receive a check from your car insurance, 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 check, and be sure to save any and all documentation related to your car repairs.

Policygenius’ editorial content is not written by an insurance agent. It’s intended for informational purposes and should not be considered legal or financial advice. Consult a professional to learn what financial products are right for you.