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Auto Loan Basics

People discussing how car loans work
People discussing how car loans work
People discussing how car loans work

How car loans work

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When you understand how auto loans work, you realize that your monthly payment includes more than the cost of the car—and that a lower payment doesn’t always save you money.

If you’re one of the majority of car buyers who use an auto loan to purchase your vehicle, you'll probably take 3-6 years to pay off that loan. That’s a lot of time and money, which makes it that much more important to understand how auto loans work. Here are the 3 major factors that affect your monthly payment and the total amount you’ll spend on your loan:

  • The loan amount. This is how much you borrow. It can be significantly less than the value of the car, depending on whether you have a trade-in vehicle and if you’re making a down payment.
  • The annual percentage rate. Usually referred to as the APR, this is the effective interest rate you pay on your loan.
  • The loan term. This is the time you have to pay back the loan, normally 36–72 months.

How those factors affect your monthly payment

When thinking about how car loans work, it’s important to understand that a lower monthly payment could also mean that you’re paying more over the duration of the loan. Let's see how adjusting each of the 3 factors can affect your monthly payment:

  • A lower loan amount. Let's say you’re considering a $25,000 car loan, but you make a $2,000 down payment or negotiate the price of the car down by $2,000. Your loan amount becomes $23,000, which saves you $44.27 per month (assuming a 3.00% APR).
  • A lower APR. Consider that same $25,000 car loan and let’s assume a 4-year term. One financial institution offers a 3.00% APR and another offers a 2.00% APR. Taking the lower APR will save you $10.98 per month.
  • A longer loan term. Extending a $25,000 loan from 4 years to 5 years (assuming a 3.00% APR) lowers your monthly bill by $104.14. However, you’ll end up paying more in interest charges over the life of the loan.

Use the Bank of America auto loan calculator to adjust the numbers and see how differences in loan amount, APR and loan term can affect your monthly payment.

How a lower monthly payment can cost you more

One of the most important aspects of understanding how auto loans work is the relationship between the loan term and the interest you pay. Extending the loan term can dramatically lower your monthly payment, but it also means you pay more in interest.

Consider a $25,000 car loan at a 3.00% APR and a 48-month term. Over 4 years of payments, you’ll pay $1,561 in total interest on the loan.

If you extend that same loan to a 60-month term, you’ll lower your monthly payment by $104—but you’ll increase the total interest paid on the loan from $1,561 to $1,953.

Weigh all the factors before deciding

There isn’t any one-size-fits-all way to determine the best value for a car loan. That’s why you need to take the time to understand how auto loans work and make the right decision for your specific financial situation.

Some people will benefit most by taking a longer term to reduce monthly payments and using the difference to pay down higher-interest debt. Some will prefer to make a higher monthly payment and pay off the total loan sooner.

And if you have an existing car loan, you may also be able to save by refinancing. Try our refinancing calculator to find out if your monthly payment might be lower by refinancing.

The choice that's right for you depends on your personal priorities and your broader financial picture. The more you know, the more equipped you are to make a smart decision that takes both the short term (the monthly payment) and the long term (the overall loan cost) into account.

Ready to get started? Compare today's auto loan rates from Bank of America.

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