An auto loan, also known as a car loan, is a type of short-term personal loan used to buy a car. It functions similarly to any other secured loan given by a financial institution, and once you take out a loan, you have to pay back the principal and interest each month. The primary distinction between an auto loan and a regular short-term loan is that the former has a clearly defined purpose, while the latter has the car as built-in collateral. If you are unable to make the installment payments and, consequently, cannot repay the borrowed funds, the car is legally repossessed by the lender.

Car loans are different from mortgages in that you don’t need any real estate collateral to apply for them, the loan granting process is simpler and shorter for auto loans, and the payback period is shorter—for a mortgage, it could be up to 30 years—while for a car loan, it’s usually between 12 and 60 months.

When comparing rates, use our auto loan calculator to get an idea of the true cost of your loan, less any additional costs that the lender might impose. All you need to do is input the desired loan amount, length, car type, and interest rate. To assist you figure out how much car you can buy, the calculator will calculate your monthly payment.

How Does a Car Loan Work?

Well, it is easier than you think. Once you find the car you want to buy, you usually know its price. Based on the calculations using that price, you should be able to work out the amount you need to borrow. In the simplest case, it is the price of the car minus the money you have.

A car loan allows you to borrow a fixed sum of money you need to buy the vehicle. After the purchase, you must repay it in fixed monthly payments, usually over one to five years (12-60 months). The interest rate is typically constant over the lending period and depends on how much you borrow. The general rule of thumb says that the smaller amount you borrow, the higher the interest rate is.

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When considering taking a car loan to buy a new car, it is worth knowing that there are two main types of financing on a car loan: direct lending and dealership financing.

• Direct lending is a typical loan taken from a bank or credit union. You sign a purchase contract with a car dealer and then use the money borrowed from the direct lender to make the appropriate payments.
• In dealership financing, a car dealer initiates the process of taking a loan and doing all the necessary paperwork. In dealership financing, you usually cannot choose the lending institution – usually, the loan is granted by so-called captive lenders associated with a car manufacturer.

Note that to promote sales, car manufacturers offer attractive financing opportunities via dealers. Usually, it is more profitable to buy a new car with dealership financing, as it is significantly cheaper – interest rates in such loans can be as low as 0.5%, 1%, or 1.5%.

Car Loan Payment Formula

Our car finance calculator uses the following formula to calculate the monthly payment:

Monthly payment = (loan amount) × (interest rate / 12) / (1 − (1 + (interest rate / 12)) ^ (-loan term)).

The interest rate is given for a period of one year.

The loan amount is the amount of money you need to borrow and is calculated as follows:

loan amount = price of the car − money you have − (trade-in value × (1 + sales tax))

where:

• price of the car — the final purchasing price;
• money you have — the cash you have to spend on a car;
• trade in value — the value of your current car; and
• sales tax — sales tax rate.

Car loan calculator – an example of calculations

Now we know the formula used in the car loan payment, we can try to perform a sample calculation.

Firstly, let’s assume that you want to buy a five-year-old Jeep Wrangler worth $20,000. You also have a car – an old Chevrolet Silverado worth about $7,000, and $1,500 in your savings account. The sales tax in your state is 10%, and the interest rate on the car loan is 4%. You want to take a three-year loan.

To calculate the monthly payments, we need to stick to the following steps:

1. Estimate the amount of money you will get for your old car. It is the trade-in value minus tax:
   $7,000 - $7,000 × 10% = $6,300
2. Calculate the amount of money you need to borrow. It is the value of a new car minus the money you get from selling an old car and money you can withdraw from your bank account: $20,000 – $6,300 – $1,500 = $12,200
3. Use the appropriate formula to compute the monthly payments: ($12,200) × (4% / 12) / (1 - (1 + (4% / 12))^(-36)) = $360.19
4. The answer is $360.19. It is your monthly payment in the loan from our example.
5. If you want to know what is the total cost of your loan, multiply your monthly payment by the number of months you will pay your loan and then subtract the total amount of the loan from that value: $360.19 × 36 – $12,200 = $766.93

You can also forget about all these long hours of counting and use our smart auto financing calculator to obtain all these values.

Pros and Cons of Taking an Auto Loan

A car loan is not the only option when buying a new car.

Probably the best solution is to buy a car outright with cash. First, it allows you to avoid monthly payments, which may be a severe burden on your budget. Moreover, paying with cash means that you do not have to pay interest, which reflects the price of borrowing, not the price of a car. Also, an outright purchase gives you full flexibility, as you can do whatever you want with the car. Last but not least, when you buy with cash, you avoid the risk of an underwater loan — the situation in which, due to the depreciation, you owe more than the car is worth. The car depreciation calculator shows how a car’s value reduces with age.

Unfortunately, not everybody can afford to buy a car with cash. Sometimes, you have to decide whether to take a car loan or lease a car. Below, you will find some pros and cons of taking a car loan.

Pros

• Auto loan is a very simple product. It is easy to arrange and understand.
• Car loan is flexible – you can choose the payback period from one to five years.
• Thanks to a car loan, you become a legal owner of the car just after the purchase. So, contrary to leasing contracts, you can immediately modify the car exactly as you desire.
• From the seller’s perspective, you are a cash buyer, so you have a stronger position in price negotiations.

Cons

• If you do not have a good credit score, you will not get a car loan.
• In the case of a car loan, the monthly installments may be higher than in other forms of financing the purchase (e.g., leasing).
• Contrary to the leasing agreements, you are responsible for the service and all vehicle repairs.
• Due to the car depreciation, your car will be worth less each year. When you decide to sell it, it will be considerably cheaper than at the time of purchase.