What a car loan is and how lenders decide whether to give you one
A car loan is money a bank or credit union lends you to buy a vehicle. You repay it in monthly installments over a set period—usually 36 to 72 months—plus interest. The lender holds the title to the car until you pay off the loan, which means they can repossess it if you stop making payments.
Lenders decide whether to give you a loan based on three main things: your credit score, your income, and how much you're putting down as a down payment. Your credit score tells them whether you've paid past debts on time. Your income shows them you can afford the monthly payment. Your down payment reduces the amount they have to lend you, which lowers their risk.
The interest rate you're offered depends on all three of these factors. Someone with a credit score above 750, stable income, and a 20 percent down payment will get a much lower rate than someone with a score of 620 and no down payment. The difference can mean thousands of dollars over the life of the loan.
Key Takeaways
- Lenders look at your credit score, income, and down payment to decide whether to lend to you and what interest rate to charge.
- Your monthly payment depends on the loan amount, the interest rate, and how many months you take to repay it.
- You can get a car loan from a bank, credit union, or the car dealership itself, and rates and terms vary between them.
- The total cost of the loan—principal plus interest—can be 20 to 40 percent more than the car's purchase price, depending on your rate and loan length.
- Pre-approval from a lender before you go to the dealership gives you negotiating power and shows you what you can actually afford.
How your credit score affects the loan you can get
Your credit score is a three-digit number that summarizes your history of borrowing and repaying money. The three major credit bureaus—Equifax, Experian, and TransUnion—calculate it based on whether you've paid bills on time, how much debt you're carrying, and how long you've had credit accounts open.
Most lenders use the FICO score, which ranges from 300 to 850. A score above 740 is considered very good. A score between 670 and 739 is considered good. A score between 580 and 669 is considered fair. Below 580 is considered poor. The higher your score, the lower the interest rate you'll be offered.
If your score is below 620, many traditional lenders won't give you a loan at all, or they'll charge you a much higher rate—sometimes 8 to 12 percent or more. If you're in this situation, you have a few options: wait and rebuild your credit before explore, find a co-signer with better credit, or look for a credit union or lender that specializes in subprime loans (loans to people with lower credit scores).
What lenders want to see about your income and debts
Lenders want proof that you earn enough money to make the monthly payment without struggling. They typically want your monthly car payment to be no more than 10 to 15 percent of your gross monthly income. If you earn $4,000 a month, most lenders won't approve you for a payment higher than $400 to $600.
You'll need to provide recent pay stubs, tax returns, or bank statements to prove your income. If you're self-employed, lenders usually want to see two years of tax returns. If you're retired, they may accept Social Security statements or pension letters.
Lenders also look at your existing debts—credit card balances, student loans, other car loans, mortgage payments. They calculate your debt-to-income ratio, which is the total of all your monthly debt payments divided by your gross monthly income. If this ratio is above 43 percent, many lenders will turn you down. If it's between 36 and 43 percent, you may still get approved but at a higher rate.
Where to get a car loan and how rates differ
You can get a car loan from three main sources: a bank, a credit union, or the car dealership itself. Each charges different rates and has different requirements.
Banks typically offer rates between 4 and 10 percent, depending on your credit score and the loan term. They require a formal process, proof of income, and a credit check. The process usually takes a few days to a week. Most banks require you to have an existing account with them or to open one.
Credit unions often offer lower rates than banks—sometimes 2 to 8 percent—because they're member-owned and not-for-profit. You have to be a member to borrow from them, which usually means living or working in a certain area or belonging to a particular employer or organization. The process process is similar to a bank's, but credit unions sometimes move faster and are more willing to work with people who have fair credit.
Dealership financing is the loan the car dealer arranges for you, usually through a bank or finance company they work with. The advantage is convenience—you can complete the entire purchase in one place. The disadvantage is that dealership rates are often higher than what you'd get on your own, sometimes by 1 to 3 percentage points. Dealerships also make money by marking up the rate they get from the lender.
How to calculate what your monthly payment will be
Your monthly payment depends on three numbers: the loan amount (the price of the car minus your down payment), the interest rate, and the loan term in months.
If you're buying a $25,000 car with a $5,000 down payment, your loan amount is $20,000. If you get a 6 percent interest rate over 60 months (5 years), your monthly payment will be about $386. If you stretch it to 72 months (6 years), your payment drops to about $333 a month—but you'll pay more interest overall because you're borrowing the money for longer.
The total amount you'll pay back is always more than the loan amount because of interest. On that $20,000 loan at 6 percent over 60 months, you'll pay about $3,160 in interest. Over 72 months at the same rate, you'll pay about $3,980 in interest. This is why a shorter loan term saves you money, even though the monthly payment is higher.
You can use a loan calculator on most lender websites to see what different combinations of loan amount, rate, and term would cost you. This helps you understand what you can actually afford before you go to the dealership.
Getting pre-approved before you shop for a car
Pre-approval means a lender has reviewed your financial information and told you the maximum amount they'll lend you and what interest rate they'll charge. It's not a may provide—the final approval still depends on the specific car you choose and a final credit check—but it gives you a clear picture of what you can afford.
To get pre-approved, contact a bank or credit union and ask for a car loan pre-approval. You'll fill out an process and provide proof of income. The lender will do a hard credit check, which temporarily lowers your credit score by a few points. The whole process usually takes a few days.
Pre-approval is valuable because it shows the dealership that you're a serious buyer with financing already lined up. This gives you negotiating power—you can walk away if the dealership's offer isn't as good as what you already have. It also prevents you from falling in love with a car you can't actually afford. Many people get pre-approved for less than they thought they could borrow, which is useful information before you start shopping.
What happens after you're approved and sign the loan
Once you've signed the loan agreement, the lender sends the money to the dealership or seller. You drive away with the car, and the lender holds the title as collateral. Your first payment is usually due 30 days after you sign.
Each month, part of your payment goes toward interest and part goes toward the principal (the original amount you borrowed). Early in the loan, most of your payment goes toward interest. As you pay down the principal, more of each payment goes toward reducing what you owe. This is why paying extra toward the principal early in the loan saves you the most money.
If you miss a payment, the lender will contact you. If you miss several payments, they can repossess the car. Once the car is repossessed and sold, you still owe the difference between what it sold for and what you owe on the loan—this is called a deficiency. A repossession also severely damages your credit score and stays on your credit report for seven years.
Frequently Asked Questions
What's the difference between a down payment and a trade-in?
A down payment is cash you give the lender or dealership upfront. A trade-in is a car you own that you give to the dealership as part of the purchase price of the new car. The dealership appraises your trade-in and subtracts its value from the price of the new car. You can do both—make a cash down payment and trade in an old car—and both reduce the amount you need to borrow.
Can I get a car loan if I have no credit history?
Yes, but it's harder. Lenders have no record of whether you pay your debts on time, so they see you as higher risk. You may need a co-signer with established credit, a larger down payment, or a credit union that works with first-time borrowers. Some dealerships also offer loans to people with no credit, but at higher rates.
What does it mean if a loan is "underwater"?
An underwater loan means you owe more on the car than it's worth. This happens when the car depreciates (loses value) faster than you pay down the loan. If you owe $18,000 on a car worth $15,000, you're underwater by $3,000. If you total the car in an accident, your insurance payout won't cover what you owe, and you'll still have to pay the difference.
Should I pay off my car loan early?
Paying off early saves you interest, which is almost always worth doing if you have the cash. However, check whether your loan has a prepayment penalty—some loans charge a fee if you pay them off before the term ends. Also, if you're struggling with other high-interest debt like credit cards, paying that down first usually makes more financial sense.
What's the difference between APR and interest rate?
The interest rate is the percentage of the loan amount you pay in interest each year. The APR (annual percentage rate) includes the interest rate plus other costs of the loan, like origination fees. The APR is always equal to or higher than the interest rate, and it's the number you should compare between lenders because it shows the true cost of borrowing.