How Does A Car Loan Work?

how does a car loan work

Let’s say you’ve picked out your dream car. You’re thrilled to cruise down the road in your new set of wheels soon—but first, you have to square away the financing. You might be asking, “How does a car loan work?”

So, how does a car loan work? Due to the fact that many people buying a new or used car choose to finance the purchase, it is a major question. Furthermore, completely understanding the answer—and the impact an auto loan can have on your credit score—will help guide you in the right direction. (You may also have a more difficult time securing an auto loan if you have a poor credit score—so keep reading to find out how you can most benefit from improving your credit score.)

How Does A Car Loan Work?

Most car loans are simple interest loans. Your monthly payment consists of two important parts: one is principal, which is the actual amount you borrowed to buy a car. The other component involves interest, the sum paid to the lender for borrowing.

Payments may include more interest at the start of the loan, and then transition into a bigger principal amount as you edge nearer to the date of payoff.

Right when you make payments over the course of the month, it can impact how much you pay in both principal and interest. If you pay early, then more of that payment goes to the principal balance. If you pay on time, then you will pay precisely the interest amount agreed upon at signing. If you pay late, then more of that monthly payment will go toward interest.

The interest, paired with any lender fees that went toward providing the loan, are factored into the APR – the “annual percentage rate” attached to your car loan.

Options For Car Loan Acquisition

How does a car loan work in terms of actually applying for one? Your options include:

  • Dealerships – Offering vehicles and loans in one place, they’re convenient spots for finance. However, rates might prove higher than your other choices.
  • Banks & credit unions – These may offer a more low-pressure environment in which to find financing.
  • Online lenders – These provide both a convenient and low-pressure method to apply for a vehicle loan at competitive rates.

What Impacts Your Interest Rate On An Auto Loan?

  • Your credit score. It informs lenders of how much risk they’re taking by lending to you.
  • The loan term. In general, shorter loans offer lower interest rates as lenders get their money back quicker. However, a short loan term might mean higher monthly payment.
  • The age of the car. New car loans typically have lower interest rates than those for used cars.
  • Money down. You can get a lower rate by showing your commitment to the purchase with a sizeable down payment.

Why & How To Boost Your Credit Score Before Getting A Car Loan

Let’s say you have a current credit score of 555. Buying a car with a credit score of 555 is a possibility, but you will most likely have to deal with a sky-high interest rate. People with bad credit – if approved for a loan – are always offered higher interest rates than someone with a credit score even just 80 points higher.

The average amount borrowed by car buyers is $27,000, according to Melinda Zabritski, Experian’s senior director of automotive credit. When you factor in the three common types of auto loans available in myFICO’s loan savings calculator — 36-month new auto loan, 48-month new auto loan and a 60-month new auto loan — you will get a good idea of how much more an auto loan will cost for someone with a credit score of 555 versus a credit score of 635.

Take a closer look:

Loan Type Credit Score Rate Payment Added Cost
36-month new auto 635 9.305% $862 $0
555 14.766% $933 $2,535
48-month new auto 635 9.325% $676 $0
555 14.774% $748 $3,469
60-month new auto 635 9.394% $566 $0
555 14.786% $639 $4,419

So you mean to say that an 80-point difference in credit scores results in a difference of $4,419—for the exact same car?

Yes, that’s precisely what we mean. Getting a car loan with a 555 credit score is going to cost you a lot more. On a 36-month new auto loan, it will cost you $2,535 more. On a 48-month loan, $3,469 more. On a 60-month auto loan, it will cost you a whopping $4,419 more.

In other words, if your scored changed to a 635—just an 80-point improvement—you would save thousands of dollars on your loan. It’s worth it to pay a company like Go Clean Credit to restore your credit before you take a test drive.

Why A Car Loan May Not Be Your Best Step To Establish Good Credit

Some people may think applying for a car loan is a decent way to start establishing credit. Well, it can actually damage your score—and you may not even be approved for an auto loan if you have poor credit.

Take a look at some of the most common—and most detrimental—mistakes when it comes to car loans when asking, “How does a car loan work?”

A Few Car Loan Mistakes That Can Cost You:

1. Negotiating the monthly payment instead of the purchase price. Buying a car based solely on the monthly payment price tag is a trap. Don’t let the dealer know how much you can afford to pay—rather, consider separately negotiating the price of each category (financing, price, etc.).

2. Letting the auto dealer set the score on if you qualify credit-wise for the car. Your credit score is what determines your car financing interest rate. Know your credit score before you head to the dealer. Also, you might consider applying for a vehicle loan beforehand.

3. Making a poor decision between either a cash rebate or a low-interest loan. Your credit score has to be healthy in order for you to enjoy low interest rate financing on your car.

Need to know more about how does a car loan work? Let us know! To enlist the help of a trustworthy, effective credit repair company, contact Go Clean Credit today.


No matter what your situation, Go Clean Credit has a solution. We have many credit repair programs that are available to help you overcome your credit situation and place you back on the path to financial success. Real credit restoration is not a once size fits all model and we tailor your needs to the right program, but most people can start for just $99 per month.

We have fixed price programs that get you back on track in as little as 5 months, debt resolution solutions, programs geared toward people who have had recent short sales or foreclosures and many others. Help is just a free phone call away, or you can fill out an appointment request. Contact Go Clean Credit to schedule a free consultation today.

One thought on “How Does A Car Loan Work?

  1. My wife and I are looking to buy a car. She needs to commute for her volunteer position, so we’re looking at financing options. I didn’t realize if you pay more on your auto loans, then the minimum it goes straight to the principal balance. I’ll be sure to remember this information moving forward.

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