How a car loan works
A car loan comes down to four numbers: how much you borrow, the APR, how many months you take to pay, and the monthly payment. The dealer will want to talk about the payment. The other three decide what the car really costs you.
The amount you borrow
This is the principal. On the contract it is called the amount financed. It starts with the price of the car, adds sales tax and fees, adds any extras you agree to, then takes away your down payment and whatever the dealer gives you for a trade in.
Everything that ends up in this number, you pay interest on. A $500 fee paid in cash costs $500. The same fee rolled into a loan costs $500 plus interest for every month of the loan.
The APR
APR stands for annual percentage rate. It is the yearly cost of borrowing, shown as a percent. It counts the interest and some of the fees the lender charges, which makes it the best single number for comparing one loan offer with another.
Federal Truth in Lending rules say the lender has to show you the APR, the finance charge (the dollar cost of the credit), the amount financed and the total of payments before you sign. They usually sit in a box near the top of the contract. Read that box. It is the deal.
The term
The term is how many months you have to pay the loan back. A longer term means a smaller payment, but you pay interest for more months, so the loan costs more in total. The lesson on long loans shows how much more.
The payment
The lender works out one fixed monthly payment that covers that month’s interest and pays the balance down to zero by the last month. Each month, interest is charged on what you still owe. Early on you owe the most, so more of each payment goes to interest. As the balance shrinks, more of each payment goes to the loan itself.
Worked example
One loan, start to finish
- Price of the car
- $22,000
- Plus sales tax and fees
- $1,800
- Less your down payment
- $3,800
- Amount borrowed
- $20,000
- APR, for example
- 7%
- Term
- 60 months
- Monthly payment
- $396.02
- Total of payments
- $23,761.20
- Total interest
- $3,761.20
In the first month, interest is $20,000 times 7%, divided by 12 months: $116.67. So of the first $396.02 payment, $116.67 is interest and only $279.35 comes off what you owe. After a year of payments you still owe $16,538.10.
Rates, prices and values here are for example only. Payments use the standard loan formula, rounded to the cent.
The totals in these lessons are the payment times the number of months. On a real loan the last payment is often a few cents different so the balance lands on exactly zero, and paying a few days early or late moves the interest a little.
Simple interest, and paying early
Most car loans charge simple interest: interest builds on the balance you still owe. That cuts both ways. Pay late and you pay more interest. Pay extra and the balance drops faster, so every payment after that carries less interest.
If you pay extra, tell the lender in writing to put it toward the principal. Some lenders treat extra money as an early payment of next month’s bill instead, which saves you nothing. Check the contract for a prepayment penalty, a fee for paying the loan off early. Many car loans have none, but some do.
What to do next
- Before you shop, decide the most you want to pay for the car in total, not per month.
- Get the out the door price in writing: price, tax, every fee and every extra, one line each.
- Ask for the APR, the term, the amount financed and the total of payments. Check them against the Truth in Lending box on the contract before you sign.
- Put your own numbers into the payment calculator and see the total, not just the payment.
- Read the next lesson, on being upside down.
Sources
Try your own numbers
Payment calculator
Your payment, the total, and how long you would be upside down.
Dealer offer X ray
The real APR, the lines you can say no to, and money the sheet hides.
Out the door price
Every fee and tax in one total, and up to three dealers side by side.
Education, not financial or mechanical advice. Have any used car checked by a mechanic you trust before you buy.