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What Is a Car Loan, and How Do You Get One?

So you need a car now, but you don't have enough money to buy one outright. If this is you, you are not alone — most Americans don't have enough cash on hand to buy even a quality used car, much less a new one. So they get a loan.

The world of car loans can be overwhelming when you are first starting out, so it's best to start with a good understanding of the basics. Understanding how a car loan works is the first step in getting a good deal on one.

Car Loan, Defined

A car loan is pretty much what you think it is: It is a personal loan, the proceeds of which are used to purchase an automobile. More specifically, a lender loans the borrower (you) the cash it takes to purchase a vehicle. In return, the borrower agrees to pay back the lender the amount of the loan plus interest, usually in monthly payments, until the amount owed is fully paid off. Pretty simple, so far. 

Oftentimes, a personal loan is an unsecured loan. That is, the loan is made purely on the basis of the borrower's trustworthiness, and not secured by some form of collateral. Car loans are different in that they are almost always secured loans, whose collateral is the vehicle itself. And that means that if the borrower fails to make his or her payments, the vehicle will be repossessed and sold to pay off the loan debt.     

The Four Basic Building Blocks of a Car Loan

1. Loan Cost 

There are two basic parts to the cost of a car loan: the principal and the interest. The principal is the negotiated cost of the vehicle itself.

The interest refers to the total amount of the costs accrued over the life of the loan based on the principal amount and the stated interest rate.

2. Interest Rate 

An interest rate is a basic rate charged to the borrower for the money loaned. The interest rate is normally expressed as a percentage for a one-year period and known as the annual percentage rate (APR).

3. Down Payment

The down payment is an upfront amount of cash paid by the borrower at the time of the purchase of the vehicle. It is usually expressed in terms of a percentage of the total price. It is not a legal requirement when taking out a car loan, but is almost always required by the lender.

4. Terms and Conditions

This refers to all of the other items that make up a car loan, including the term of the loan, normally stated in a number of months or years; insurance and registration requirements; loan payoff and resale terms; maintenance requirements; conditions regarding theft or accident; and conditions of loan default and repossession. There are many other such conditions, and a borrower is well advised to read them over carefully and have a clear understanding of what they mean before signing on.

The Car Loan Process

Here are five basic steps you will likely follow in the process of securing a loan for your new vehicle:

1. Determine What You Can Afford

Get out a piece of paper and work out a realistic budget that tells you what you can afford in terms of a monthly payment. Then decide how long you are willing to have your loan last — the term of your loan. Next, determine the amount of the down payment you plan to make. The result will tell you how much car you can afford to buy.

2. Check Your Credit Score

It's important to know exactly where you stand in regard to your credit score before talking to lenders. Lenders rely on credit reports and scores when determining loan interest rates and terms. The higher your credit score, the better position you will be in to lock in a lower rate. 

3. Shop Around for the Best Loan Deal 

This is important since rates and terms will vary, sometimes considerably, between lenders. It's also important to look for the best loan deal before heading out to shop for a car.

4. Get Approved 

Getting pre-approved for your loan means that you've set your limits before setting foot in a dealer's showroom where your emotions might get the best of you and your pocketbook. The best places to look for a pre-approved loan are banks and credit unions. 

5. Shop for Your Car 

Now it's time to visit your local auto dealers. Find the exact car you want. Then let your lender know the year, make, model, and Vehicle Identification Number. You will also need to purchase car insurance as soon as possible.

Most dealers will not let you drive away without showing proof of car insurance.

Two Ways to Improve Your Chances of Getting a Car Loan Approved

1. Get a Co-Signer

Is your credit score too low (or nonexistent) to qualify for a decent car loan? A co-signer can change all of that. A co-signer is putting their name and credit score on the line for your purchase. If you do not pay, their credit will be affected the same way as if the loan were solely in their name. Typically a co-signer is a very close relative such as a parent. It is a good way for you to establish credit and build a great credit score.

2. Peer to Peer Auto Loan

Can't find a co-signer to back you? Several peer to peer auto loan websites are available to help connect lenders and buyers. Your credit score will be run, and you will be slated "high risk" if you have a low or non-existent score. The higher the risk of the loan, the higher the interest rate. It is another lending source whether or not your credit is good or bad.

A Few Car Loan Tips

Be sure to check on the reputation of your lender and read the fine print of the loan agreement before signing anything.

And don't forget to check the math. Make sure that the numbers add up and match those that you and the lender agreed to.

One more thing: Stay away from "conditional" or "contingent" loans. That's where you sign a loan agreement with a dealer and drive away with your new car before all of the terms of the loan have been finalized. Important items such as interest rate, loan period, down payment and the amount of the monthly payment may be changed (almost certainly to your disadvantage), and you could be stuck paying a lot more than you intended.   

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