How Does a Car Loan Work?

A set of wheels can mean independence, easy mobility and personal freedom. But with the good things also comes the obligation to pay for the vehicle, and unless you have enough cash available you'll need to negotiate a car loan. The process of borrowing money for a car can be fraught with tricks, traps and fees, and navigating this winding road will involve the careful study of a loan contract's very small print.

For many buyers, negotiating the purchase price of a car is just the first step in the transaction. Finding the money to pay that price often means taking out a car loan, which in turn requires finding a lender willing to extend credit. Banks, credit unions, finance companies and dealers all can extend auto loans. A dealer can't require a buyer to use a specific lender, but each lender has guidelines that set interest rates, repayment terms, and fees on the credit they extend to buyers. The higher your credit score, the lower your interest rate will be, meaning the less that borrowed money will cost. Buyers with poor or no credit can expect to pay higher interest rates, or may need to bring a cosigner into the deal.

State and federal laws govern car loan contracts. On every such contract will be some important numbers: the total amount financed, the interest rate, the annual percentage rate, the total cost of credit, and the repayment period. The contract also will reveal any charges for the loan that have been rolled into the cost of the vehicle, and any optional services the dealer has convinced you to buy, such as extended service contracts, credit insurance and weatherproofing.

A car loan works much like other types of loans. You'll pay a flat monthly amount which covers principle and interest by a fixed due date each month. The lender may set up an automatic withdrawal from your checking account, or provide you with a book of repayment coupons which you send in with your check each month. At any time, you can contact the lender for a payoff amount. This is the remaining principle balance, which will terminate the loan if you're able to pay it. If you miss a payment, the lender will charge a late fee.

If you fall behind on a car loan, it's best to contact the lender to explain the situation and request their patience. This may result in permission to skip a month's payment without a late penalty. If the loan defaults, the car provides the security. The lender will have the right to file a request in court for a writ of repossession. If the court complies, the lender then has an order in hand that will permit it to have the car seized. Allowing a repossession to happen does not cancel the loan, and the vehicle may be worth less than the loan balance. In addition, a repo will show up on your credit report, drag down your credit score, and turn any future loan application into a serious hassle.