Understanding How Auto Loans Work

Kimberly Knight

Contrary to popular opinion, a lower monthly car loan payment doesn’t always mean you are saving money. Auto loans have a lot of factors that determine how they work. Chances are that if you are in the market for a new car, you are going to need to take out an auto loan to finance your purchase. 


If you are willing to borrow thousands of dollars to purchase a vehicle, it is also necessary for you to thoroughly understand how these loans work.


 

When a financial institution issues you a car loan, they send you a lump sum amount of money that you must pay back (plus interest) over a set period of time. The amount you borrow, the time you take to pay it back and your granted interest rate determines the size of your monthly payment. 

Here are the 3 factors that affect both your monthly premiums and the total amount you end up paying:


 



  1. The loan amount: depending on how big your down payment is or if you’re trading in a vehicle, your loan amount can be significantly lesser than the value of the car.

  2. The APR or annual percentage rate: this is the effective interest rate that is applied to your loan amount.

  3. The loan term: this is the set period of time within which you must pay your loan back. It typically ranges between 36–72 months.


 

How do these 3 factors affect your monthly premium?

The three factors we mentioned above play a huge role in determining how much you have to pay every month. 

Although a lower monthly payment sounds ideal while planning your monthly finances, it can have a long-lasting effect on your bigger financial picture. That lower monthly premium means taking a long time to pay the loan back, adding more interest to your loan amount, causing you to pay more than what your car is worth! 


 

Let’s say you’re planning on taking out a $25,000 car loan at a 3.00% APR and a 48-month term. 

Over this 4 year payment period, you’ll pay $1,561 in total interest. If you extend the same loan to a 60-month term (or 5 years), you might lower your monthly payment, but you’ll increase the total interest you'll pay from $1,561 to $1,953.