How Do Car Loans Work? A Guide To Auto Loan Financing

Car financing is a common way Americans buy vehicles. Many consumers wonder, "How does getting a loan for a car work?"

What is Car Financing?

Car financing is when money is borrowed from a lender to purchase a vehicle. The car, truck, or SUV being purchased is collateral for the loan.

The borrower repays the loan by making regular payments over a specified amount of time. These payments include paying back the amount of the car loan and the loan’s interest. Interest rates can vary widely among lenders. The loan applicant’s creditworthiness is an important factor in determining the interest rate. They are also tied to the current base interest rate set by the Federal Reserve.^[1]

Many loans require a downpayment but zero-down car loans are sometimes an option. Your lender will likely require you to have a full-coverage auto insurance policy on your car to protect their lender.

Key Terms You Should Know

Every car loan contract comes with language that's important to understand.

Downpayment: A downpayment is the amount of money you put down on the vehicle at the time of purchase. For example, if you buy a vehicle for a total cost of $20,000 and put $2,000 toward it at the time of purchase, your downpayment is $2,000, and you only have to finance $18,000.

Principal: Principal is the sum of the amount you financed. It may include the cost of the vehicle, any taxes and on-road fees, and any other add-ons to your car, such as winter mats or tires, minus any downpayment. This is the amount that the dealership receives once the lender funds your loan.

Interest: Interest is the amount you pay to the lender for extending the loan.

Interest Rate: This is the rate of interest you pay as a percentage of your loan. For example, 4.9% annual interest means you pay 4.9% of the of the loan each year or $490 on a $10,000 loan each year. However, there may be other fees and charges that apply to your loan above and beyond the interest rate.

Annual Percentage Rate (APR): This is the actual cost of your loan each year as a percentage of the loan. It includes the interest rate, plus any fees associated with the loan. The APR is usually higher than your actual interest rate.^[2] For example, if you have a $10,000 loan with a 4.9% interest rate, you'll pay $490 a year in interest. If you also pay $120 a year in fees, you end up paying $610 per year in interest. That is 6.1% of your $10,000 principal, so the APR is 6.1%.

Loan Term: This is the amount of time it takes to pay off your loan, usually expressed in months. For example, a four-year loan term is 48 months.

Monthly Payment: Your monthly payment is the amount you need to pay each month to repay the loan.

Types of Auto Financing

There are two main ways to finance your car: financing through a dealership (indirect lending) and financing through a financial institution (direct lending).

Dealership
Financial Institution
Leasing A Vehicle
Loan Pre-Qualification
Loan Pre-Approval

Dealership financing is common and often considered a convenient option. Many dealerships may let you apply for a loan on a vehicle on-site and, if you qualify, could provide an answer quickly. Dealerships may emphasize financing through them because it can give them commission revenue for arranging financing and helps them have more control over the deal.

A typical dealership financing experience looks like this for you as a buyer:

Visit a dealership to look at a car
Work with the salesperson to negotiate a price
Meet with a finance agent who initiates the loan application process
Get a loan offer if you meet the required qualifications
Decide whether to accept the offer
Sign required paperwork and leave with your new vehicle

Direct lending is when you take out a loan directly with a lender. It might be your own bank or credit union or another financing source, including an on-line lender. This allows the buyer time to cross-shop different loans and bundles and even make sure the loan terms suit their needs.

Here's how to finance a car with direct lending in typical cases for you as a buyer:

Conduct research for the best loan rates and terms
Submit an application directly with the lender
Get approved for a certain loan amount if you meet the required qualifications
Shop for a vehicle
Find a car and negotiate a price
Submit the vehicle's information to a chosen lender who will disburse the funds to the dealership or current owner
Sign required paperwork and take possession of the car

A car loan isn't the only way to pay for a vehicle without using cash. Leasing is another option to explore.

Leasing a car usually means paying a monthly payment for a set period of time and then choosing from two options:

Pay or finance the balloon payment (the amount left over on your leased vehicle after the car lease term is finished) with a lease buyout loan
Return the car to the leasing company

In this scenario, you never own the vehicle unless you finance your car lease buyout or pay out the balloon payment once the leasing period ends.

When considering leasing a vehicle, it's essential to look beyond the appeal of lower monthly payments and the potential for a balloon payment at the end of the lease.

It's important to be aware that when you return the car to the leasing company, additional charges may be added to your payoff amount, including the following:

Mileage: Many leases come with an annual mileage cap, which may range from 10,000 to 15,000 miles per year. If your car's mileage exceeds this limit, you'll face additional charges, often calculated on a per-mile basis.
Wear and tear: Lease agreements often require you to return the vehicle in good condition, which includes addressing any wear and tear, including small scratches, dents, and interior damage. Leased vehicles are generally expected to be in near-new condition upon return.
Early termination: If you need to end your lease before the agreed-upon term, be aware that early termination can be costly. These fees can include the remaining balance of the lease payments and potential penalties for breaking the contract.
Customization: Modifications such as new paint jobs, aftermarket parts, or custom interiors are generally prohibited. If you make modifications, you may need to revert the vehicle to its original condition before returning it or face additional costs.

Many lenders offer programs commonly known as prequalification and preapproval. The terminology used and the programs can vary among lenders, so you should ask a lender about its programs and their details so you know what to expect. Both pre-qualification and preapproval can provide valuable insights into your financing options, but they serve different purposes.

Pre-qualification is often provided as an initial step where a lender presents general information about the car loan programs and loan amount that may be available to you, based on preliminary financial information you provide and your permission for the lender to obtain a partial credit report from a credit reporting agency. This is often referred to as a “soft credit pull”. A “soft credit pull” does not affect your credit score because it is not associated with a specific application for credit, unlike a “hard inquiry”, discussed below.

Pre-qualification may be beneficial for a couple of reasons:

It helps you to set a realistic budget by estimating how much you can afford to borrow.
It allows you to compare potential terms from different lenders without affecting your credit score.

Since pre-qualification is not and does not guarantee loan approval, it’s important to remember that the terms you receive are estimates and could change if you proceed with a full loan application.

Preapproval usually entails reviewing your financial history and a full credit report. Unlike pre-qualification, preapproval requires a “hard credit inquiry,” that can impact your credit score. The “hard inquiry” will be part of your credit file for up to two years, although most credit scoring models only consider hard inquiries for the previous twelve months. According to one credit model source, a hard inquiry can temporarily lower your credit score by five points or less, although a strong credit history may result in a lesser decrease than that.^[3] You submit a detailed application during preapproval, including proof of income and employment verification. The lender then performs a comprehensive evaluation and provides a preapproval letter stating the specific loan amount, interest rate, and terms for which you qualify. The preapproval is not final loan approval and it is usually subject to conditions, which can vary by lender. A typical condition is that the applicant’s credit profile does not have an adverse change between preapproval and final approval. Final loan approval requires a complete loan application including information about the vehicle to be purchased. The lender will usually perform a “hard inquiry” to obtain a full credit report to confirm that there was no negative change in the applicant’s credit profile.

According to one credit model source, a hard inquiry can temporarily lower your credit score by five points or less, although a strong credit history may result in a lesser decrease than that. You submit a detailed application during preapproval, including proof of income and employment verification. The lender then performs a comprehensive evaluation and provides a preapproval letter stating the specific loan amount, interest rate, and terms for which you qualify.

The preapproval is not final loan approval and it is usually subject to conditions, which can vary by lender. A typical condition is that the applicant’s credit profile does not have an adverse change between preapproval and final approval. Final loan approval requires a complete loan application including information about the vehicle to be purchased. The lender will usually perform a “hard inquiry” to obtain a full credit report to confirm that there was no negative change in the applicant’s credit profile.

The preapproval process may offer several advantages:

A preapproval letter informs car dealers that your credit has been approved by a lender, which may give you an advantage in negotiations.
It also allows you to shop confidently, knowing exactly how much car you can afford.

To minimize the impact on your credit score, it’s often advisable to complete any preapprovals within a short timeframe, typically 14 to 45 days. Credit scoring models often treat multiple inquiries for the same credit type, which may count as a single inquiry if they occur within a short window.^[4]

How to Budget for a Vehicle Loan

A strategic approach to budgeting can help ensure that your car loan payments are affordable and that you maintain overall financial health. Start by evaluating the following:

Monthly Income

Determine your total monthly income after taxes. This is your take-home pay and will be the basis for budgeting decisions.

Monthly Expenses

Make a list of your fixed and variable monthly expenses.

Savings Goals

Consider your short-term and long-term savings goals, including your emergency fund, retirement savings, or a down payment for a future home.

How to Allocate Take-Home Pay for Car Payments

Many financial experts recommend limiting total car payments to 10-15% of your take-home pay.^[5] This helps ensure that your car loan remains affordable and doesn’t negatively impact your ability to cover other essential expenses and savings goals.

If you have numerous debts or other financial obligations, consider staying closer to the 10% threshold. If your financial situation is more flexible, 15% may be the right choice.

Here are some practical steps to help you budget effectively for a car loan:

Ensure that the total cost of owning the car, including the loan payment and other expenses, fits comfortably within your budget.
A larger down payment reduces the total loan amount and monthly payments. Aim to save at least 20% of the car’s purchase price.
While longer loan terms can lower your monthly payment, they may result in higher overall interest costs. A typical recommendation is to choose a loan term of 48 to 60 months.
Compare loan offers from different lenders. A lower interest rate can reduce your monthly payment and total loan cost.

How Different Loan Terms Affect Monthly Payments and Total Interest Paid

Understanding how loan terms impact your monthly payments and total interest paid is crucial when deciding on a loan.

Consider How These Loan Terms Fit Within Your Overall Budget

Monthly Payment

A shorter term might mean you pay less in total interest over the life of the loan. However, a shorter term requires higher monthly payments, which might strain your budget. Ensure you can comfortably afford the payment without compromising other essential expenses.

Total Interest

A longer term might offer lower monthly payments, making it easier to manage month-to-month. However, the higher total interest paid means you’ll spend more over the life of the loan.

Here are examples to illustrate the effects of varying loan terms with an interest rate of 7%:

Short-Term Loan (36 Months)

Loan amount: $25,000
Interest rate: 7%
Monthly payment: $771.91
Total interest paid: $2,789.39

Medium-Term Loan (48 Months)

Loan amount: $25,000
Interest rate: 7%
Monthly payment: $598.66
Total interest paid: $3,375.49

Long-Term Loan (60 Months)

Loan amount: $25,000
Interest rate: 7%
Monthly payment: $495.03
Total interest paid: $4,701.80

Extended-Term Loan (72 Months)

Loan amount: $25,000
Interest rate: 7%
Monthly payment: $426.23
Total interest paid: $5,688.21

Why Choose PNC for Your First Auto Loan?

As one of the largest diversified financial services institutions in the United States, our focus is to be a resource with innovative offerings and digital solutions that allow us to provide a borrowing experience that’s simple and easy to navigate.

Conveniently Apply

Apply online, by phone or at a branch. If approved, take your PNC Check Ready check to any eligible dealer.^[6,7]

Get 0.25% Off Your Rate

Interest rate discount comes with maintaining automated payment with a PNC checking account.^[8]

Negotiate Your Deal

If approved, write the PNC Check Ready check up to the approved loan amount.^[6]

Auto Loan FAQs

Most lenders may require that you provide the following items for a loan application Identification:

Proof of income
Proof of insurance
Proof of address
Vehicle information, including year, make, model, and Vehicle Identification Number (VIN)

Lenders need your VIN to make sure the vehicle has no liens on it, no prior record, and that it's identified as being in possession of the seller. A lien can be recorded against the VIN until the loan is paid in full.^[9]

Your credit score is one measure of your risk profile for a lender. A high credit score indicates lower repayment risk for a lender. They see a high credit score as a sign of responsible credit use. A low credit score is usually viewed as a greater repayment risk for a lender. Many things can affect a person's credit score. A poor credit score may not prevent a person from obtaining credit, but it usually leads to a higher interest rate.

Credit score ranges vary across credit score models. One model groups credit scores as:

Excellent (800 -850)
Very Good (740-799)
Good (670-739)
Fair (580-669)
Poor (300-579)

The interest rate available to you could vary depending on your credit score.^[10]

A responsibly managed car loan can help increase your credit score by enhancing credit mix and building positive payment history.

A car loan adds an installment loan to your credit profile, which can help enhance your credit mix. Many credit scoring models favor a diverse mix of credit types, including revolving credit (like credit cards) and installment loans (like car loans, mortgages, and personal loans).

Payment history is a significant factor in determining your credit score. Regular, on-time car loan payments will contribute positively to your credit history, showing lenders reliability in repaying borrowed money. Timely car loan payments are a positive addition to your credit report, which can boost your credit score over time. Missed or late payments can lower your scores.

Take Your Next Steps

Visit Our Auto Section

Explore borrowing options for new or used cars.^[6] Try our helpful tools and calculators.

Visit Page

Visit Our Lending Portal

Interested in other PNC Lending Options? Our Lending Portal is here to help you find the solution that meets your needs.

Visit Page

Auto Loan Calculator. Bankrate November, 2024
https://www.bankrate.com/loans/auto-loans/auto-loan-calculator/
What is the difference between a loan interest rate and the APR? Consumer Finance January, 2024
https://www.consumerfinance.gov/ask-cfpb/what-is-the-difference-between-a-loan-interest-rate-and-the-apr-en-733/
Hard Credit Inquiry vs. Soft Credit Inquiry: What they are and why they matter Credit Karma October, 2024
https://www.creditkarma.com/advice/i/hard-credit-inquiries-and-soft-credit-inquiries
Hard Inquiry vs. Soft Inquiry: What’s the Difference? Experian October, 2024
https://www.experian.com/blogs/ask-experian/hard-inquiry-vs-soft-inquiry/
Is your car payment too expensive for your monthly budget? Bankrate January, 2024
https://www.bankrate.com/loans/auto-loans/car-payment-too-expensive-for-budget/
Loans are subject to approval. Certain restrictions and conditions apply.
Eligible Dealers: Checks may only be used at dealers licensed to sell new vehicles from a manufacturer such as Ford, Kia or BMW or from an eligible dealer found on pnc.com/checkready. Checks up to the approved loan amount may be used to purchase new or used vehicles from such dealers. Before visiting a dealer, confirm that it is an eligible dealer. For more information, visit pnc.com/checkready.
Automated Payment Discount: Automated payment must be set up at loan closing from a PNC checking account to qualify for the 0.25% discount. If automated payment is discontinued at any time, you may no longer receive an automated payment discount and your rate will increase 0.25%
Guide to Car Liens: Lien Titles, Lienholders & More. Carfax October, 2022
https://www.carfax.com/buying/car-lien-title
Average Car Loan Interest Rates by Credit Score. Experian October, 2024
https://www.experian.com/blogs/ask-experian/average-car-loan-interest-rates-by-credit-score

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