When seeking a quality vehicle, one common step is getting an auto loan to pay for it. On the surface, a car loan looks simple. You apply for it, the lender approves you, and you drive off in your used or new vehicle.

However, there is a lot more to an auto loan than meets the eye, and answering the question, “how does a car loan work?” can give you all the details on the money you need to borrow to buy your vehicle. Continue reading to learn more about how auto loans work.

Where Can I Get a Car Loan?

There are plenty of places you can get an auto loan. Here are some more common ways to secure financing for your next vehicle.

Bank or Credit Union

You can go to nearly any bank or credit union and speak with a loan specialist about getting an auto loan. If you are a current customer, they may even offer you special financing options. For a credit union, you may need to become a member to apply for a car loan.

The benefits of using a bank or credit union are that you always have a branch to walk into and ask questions and you can shop as a cash buyer with the bank’s pre-approval. However, brick-and-mortar banks and credit unions don’t always have the strongest interest rates.

Online Auto Lenders

There are also online lenders dedicated to auto loans. They will review your credit score and issue you a decision almost immediately. Searching “auto loans” online will turn up countless options that you can compare to find the best option.

As with a bank, pre-approval from an online lender means you’re essentially walking into the dealership as a cash buyer. Some will even mail you a cheque that you fill out to pay for the vehicle, streamlining the car-shopping process. Plus, with limited overhead expenses, online lenders can sometimes offer lower interest rates.

The downside is there’s usually no local branch to walk into with questions. You’ll have to call customer service and wait on hold.


Most car dealerships will have relationships with a handful of lenders. The dealership’s finance department will submit your credit report and score to their lending partners to see which offers the best loan terms.

The main benefit to securing financing at a dealership is convenience. All you do is find the car you love, and the dealership handles the rest. Plus, because the dealership has a relationship with the lender, it may be able to push through difficult cases that may be otherwise rejected.

Buy-here-pay-here financing

The final financing option is to go to a buy-here-pay-here car dealership and use its in-house financing option. While these dealers have more flexibility in approving people with bad credit and other issues in their credit history, they also tend to come with high interest rates and monthly payments.

What are Interest Rates and APR?

With virtually every loan — car loans included — its repayment terms will include an interest rate and APR. The interest rate is the percentage of the loan the lender is charging you as a fee for lending you the money. Interest is generally calculated daily or monthly, depending on the lender.

A loan’s annual percentage rate (APR) is the annualized amount you’ll pay in total interest plus any additional loan fees, like administrative fees or origination fees, added up and expressed as a percentage of the loan amount. It’s not common for an auto loan to have additional origination or administrative fees, so the APR and interest rate are often the same.

Because interest is added as the loan ages, the earlier you pay it off, the more money you’ll save overall.

What Is a Down Payment?

Your down payment is the initial lump sum you pay for the car, leaving the remaining balance of the car to be paid by a loan. The down payment can be at your discretion, but sometimes a lender will dictate the down payment it needs to approve you for the loan — more on this below.

Essentially, the larger the down payment you pay, the less you need to finance and the lower your monthly payment is. A larger down payment can also help lower your interest rate, further reducing your monthly loan payment.

How Does a Trade-In Vehicle Impact the Loan?

When you trade in a vehicle, it can impact your car loan. First, the equity in the vehicle will help reduce the overall amount you’re financing. The equity is the trade-in value the dealership gives you minus any loans or liens on the vehicle.

For example, if you owe $10,000 on a vehicle, and a dealership offers you $15,000 on a trade, you have $5,000 in equity.

Plus, you only pay harmonized sales tax (HST) on the new vehicle’s value after the trade-in amount is deducted. So, if you applied that $5,000 in equity to a $25,000 vehicle, you’d pay HST on just $20,000, further reducing your loan amount.

How Your Credit Score and Report Can Impact a Car Loan Application

Your credit score and credit report can significantly impact your auto loan, both in terms of the interest rate and whether or not you even qualify. Here are some red flags lenders look for and how these red flags can impact your auto loan.

Low credit score

A low credit score is one of the first red flags a lender will look for. A low score indicates that you struggle to make on-time payments to your creditors, have too much debt, lack experience in using credit, or have recently applied for numerous new credit accounts.

A low credit score can lead to a rejection, but it may also result in a higher interest, a higher down payment requirement, or a cheaper vehicle.

High Debt-to-Income Ratio

Your debt-to-income (DTI) ratio is your total monthly minimum debt payments divided by your monthly income. Lenders have their preferred DTI ratios, and if your DTI is too high, the lender may reject the loan or increase the interest rate because of the higher risk.

High Credit Utilization Ratio

Your credit utilization ratio — your total revolving debt balances divided by your total revolving credit limit — impacts your credit score, which in turn can impact your car loan. However, some lenders have set guidelines for an acceptable utilization ratio. If your ratio exceeds this, you could be rejected or get a higher interest rate.

New Car Loan Vs. Used Car Loan

Auto lenders see new cars as a lower risk purchase than used cars, leading to lower interest rates on new cars versus used cars. In fact, some captive lenders — those attached to a specific automaker — offer as low as 0% interest.

This can make new cars tempting, but the interest savings are often more than offset by a pre-owned vehicle’s reduced cost. Plus, used cars have a far slower depreciation rate than new cars.

Where Is the Title on a Financed Vehicle?

When you have a title in hand under your name, you can sell the vehicle as you please. No lender wants to run the risk of you selling the vehicle and skipping out on your payments, so lenders hold the title until you pay off the vehicle. Once you pay off the loan, the lender will send you the title.

How to Make Monthly Car Payments

Most lenders offer a few payment options, giving you several ways to get your monthly payments to them.

Mail-in Payment

When you receive your monthly car loan statement, it’ll include a payment coupon and an envelope. Simply mail the cheque and coupon in the provided envelope. Make sure to leave a few days between the day you mail the payment and its due date to allow the payment to arrive on time.

Online payment

Most lenders today have at least a website with online payment options, and some even have a mobile app to make it easier. You can make your payment through this system and have it sent to the lender instantly, but be aware of any potential processing fees.

Online bill pay

Many banks today offer free online bill pay. You simply enter your lender’s information, and the bank will either wire the money or mail a paper cheque. Either way, always put your loan number on the memo line, since your payment coupon, which has your loan number on it, will not be included with the payment.

Can You Refinance an Auto Loan?

Refinancing is possible with a car loan, but because they are a depreciating asset and generally have short financing terms, there are a few items to consider.

First, you only want to refinance at select times. One ideal time is if you had bad credit when you bought the vehicle leading to a high interest rate, and you now have a good credit score. This credit score boost could help you secure refinancing with a much lower interest rate.

Second, you should compare the total cost of the refinancing package to what costs remain on your loan. This will involve going through your amortization schedule, which you can get from your lender, and adding up all your remaining interest payments. Then, simply compare the remaining costs on your loan to the total loan costs on the refinancing loan. If the refinancing loan costs more, it’s not a worthwhile deal.

Third, you want to avoid extending your loan terms to lower your payment. Instead, refinance at the loan term remaining on your existing loan. For example, if you have 36 months remaining on a five-year auto loan, you want to refinance for 36 months. This way you remain on track to pay off the loan in the same time and don’t run into additional depreciation on a financed vehicle.

Can You Pay Off a Car Loan Early?

Yes, you can pay a car loan off early. This not only eliminates another payment from your monthly budget, but it can also save you thousands in interest charges over the life of the loan. However, read your loan documents carefully to ensure there’s no prepayment penalty.

You should request a loan payoff statement to pay off your car early. This will give you a close estimate of how much you need to pay within a certain number of days to pay off your vehicle fully. This is important because interest is calculated and added to the loan daily — this estimate accounts for the accrued interest.

You can pay your vehicle off by mailing a cheque, online payment, or online bill pay. However, carefully follow the instructions on the payoff statement, as you may need to send the payment to a special address to expedite the payoff and mail your title to you.

Get Your Car Loan and Quality Pre-Owned Vehicle at Clutch

At Clutch, Canada’s first 100% online pre-owned auto retailer, we not only offer a range of quality in-stock vehicles, but we can also arrange financing for you. Fill out our online credit application, and we’ll get back to you with a decision within 24 hours.

While you wait, check out our massive inventory of quality pre-owned vehicles. All our vehicles have been through a 210-point inspection and reconditioning process to ensure they’re ready for the road. We also add a 90-day or 6,000-km warranty for good measure.

Also, your online car purchase is covered by Clutch’s 10-day or 750-km test-own period. If you don’t love your Clutch vehicle during this time, exchange it for a different vehicle or return it for a refund, no questions asked.

Come check out our selection of quality pre-owned vehicles and our strong used car loan offers today.