Q:

How do car loans work?

A:

Quick Answer

An auto loan is vehicle financing set up through a direct lender or a dealership, according to the Federal Trade Commission. The lender provides funding to help a person pay for the auto purchase. In exchange, the borrower agrees to repay the debt with interest over a defined repayment term.

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Full Answer

Car loan terms typically range from two to eight years as of 2014. However, a five-year, or 60-month, term is optimal, according to Autobytel. The goal in selecting the repayment length is to set up an affordable monthly payment while minimizing the amount of interest paid over time.

A lender runs a buyer's credit report prior to make a loan offer. The actual interest rate offered depends on the buyer's credit rating as well as the loan term. Someone with excellent credit may have access to a 0 percent financing offer with a relatively short repayment period, according to Autobytel. Generally, shorter loan terms lead to the lowest interest rate because the lender gets its money back sooner.

After the auto purchase, the borrower makes monthly payments to the lender that include principal and interest. Paying more than the minimum is a way to shorten the loan term and reduce the interest paid. Making late payments or defaulting on an auto loan can seriously damage a person's credit, according to Autobytel.

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