How do car loans work?

A car loan is a fixed monthly payment for a set number of months, and the APR and the term decide what the car really costs. A longer term lowers the payment but adds interest and raises the chance you owe more than the car is worth.

APR and term set the cost

The APR is the yearly cost of borrowing, including interest and some fees. The term is how many months you pay. A higher APR or a longer term both add to the total interest.

Long terms cost more

A 72 or 84 month loan has a lower payment, but you pay interest for more months on a balance that shrinks more slowly. The same loan can cost thousands more.

Upside down means you owe more than it is worth

Cars lose value as they age, often fastest in the first few years. A small down payment plus a long term can leave you owing more than the car would sell for.

20/4/10 is a guideline

Put at least 20% down, borrow for no more than 4 years, and keep car costs at or below 10% of pre-tax income. It is a rule of thumb, not a law, and versions differ.

How an auto loan is built

An auto loan is an installment loan. You borrow a set amount, usually the price of the car minus your down payment and any trade-in, and repay it in equal monthly payments. Each payment covers that month's interest first, and the rest lowers the balance.

Early payments are mostly interest. Later payments are mostly principal. The car is the collateral, so if you stop paying, the lender can repossess it.

What APR means for your payment

The APR is the yearly cost of the loan as a percentage. It depends on your credit, the age of the car, the term and the lender. A few points of APR can change the total by hundreds or thousands of dollars.

Shopping around helps. Get quotes from a bank or credit union before you visit the dealer. Several auto loan applications within a short window are usually treated as one inquiry by credit scoring models, so comparing offers does limited harm to your score.

Why 72 to 84 month loans cost more

A longer term spreads the same balance over more payments, so each one is smaller. But interest is charged every month on what you still owe. With more months and a balance that falls more slowly, the total interest grows.

Longer loans also often come with higher APRs than shorter ones. And you may still be paying for the car after the warranty ends, when repair bills tend to start.

Being upside down on a car

You are upside down, also called negative equity, when your loan balance is higher than the car's value. It happens most with small down payments and long terms, because the car loses value faster than the loan shrinks.

It becomes a problem if the car is totaled, stolen or sold. Insurance pays the car's value, not your loan balance, so you could owe the gap. Rolling that gap into your next car loan makes the new loan bigger from day one.

Using the 20/4/10 guideline

The 20/4/10 rule is a quick check for affordability. Put at least 20% down, finance for no more than 4 years, and keep total car costs, such as the payment and insurance, at or below 10% of gross monthly income.

Treat it as a starting point. If you have high-interest debt or no emergency fund, aim lower. If the numbers don't work, look at a less expensive or used car before stretching the term.