Car Deal Canada

How Car Loans Work

How Car Loans Work

Buying a new or used car is an exciting milestone. However, with the average price of a new vehicle now over $45,000 in Canada, most buyers need to finance their purchase through an auto loan. In fact, 86% of all new cars and 55% of used cars are purchased with financing.

While auto loans make owning a vehicle more affordable, it’s critical to understand exactly how they work before signing on the dotted line. Auto loans can be beneficial by spreading out payments over time, but also risky if you fall behind.

In this comprehensive guide, we’ll walk through every aspect of auto loans, from the application process to calculating your monthly payments. You’ll learn insider tips to land the very best loan terms and avoid financial pitfalls. We’ll also outline the pros and cons to weigh when deciding if financing is right for your situation.

Let’s get behind the wheel to explore how auto loans really work!

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What is an Auto Loan?

An auto loan is essentially a type of installment loan that allows you to borrow money to purchase a car. The car itself serves as collateral on the loan until you finish making all your payments over the loan’s set repayment term, usually between 24 and 84 months.

With an auto loan, you own the vehicle once you pay off the loan in full. This differs from leasing a car, where you make lower monthly payments but never actually own the vehicle. At the end of a lease, you simply return the car unless you decide to buy it outright.

Auto loans provide the financing to pay a car dealership or private seller for the entire cost of a vehicle upfront. Then the lender allows you to repay the loan amount plus interest over time through a monthly payment schedule. These set payments are predictable and spread out the high cost of a car over several years.

Since the vehicle serves as collateral for the loan, the lender can repossess it if you stop making payments. But as long as you continue making your monthly payments responsibly, you get to keep driving the car while also building equity and ownership.


How the Auto Loan Process Works

There are several steps involved in obtaining an auto loan in Canada:


Applying for an Auto Loan

The first step is to apply for financing. This involves:


  • Checking your credit score and history to understand what rates you may qualify for
  • Researching different lenders and loan options to compare rates and terms
  • Submitting a loan application with proof of income, employment, and other financial details
  • Getting approved for a loan offer if you meet the lender’s requirements


Getting Approved at the Dealership

Many people arrange financing when purchasing from a car dealership. The dealer will help you apply and get approved through their network of partner lenders. This can simplify the process but may limit your lender options.


Getting Approved Directly Through a Lender

You can also apply directly with banks, credit unions, or other lenders you already have a relationship with. This allows you to easily compare loan offers from multiple providers.


Getting Pre-Approved

Getting pre-approved before visiting dealers gives you strong negotiating power. You’ll know exactly how much financing you qualify for ahead of time when determining your budget and negotiating price.

Once approved, you can use the loan funds to complete your vehicle purchase. Remember, the loan money must go directly to the registered seller, not to you personally.


Getting Pre-Approved for an Auto Loan

Getting pre-approved for an auto loan before visiting dealerships gives you a better negotiating position and more options. Pre-approval is when a lender reviews your credit and finances and provides you with a loan offer before you actually purchase a vehicle. This allows you to know upfront exactly how much you can borrow, along with the interest rate and terms you qualify for based on your credit score and financial situation.

Pre-approval gives you greater confidence and negotiating power when dealing with car salespeople, since you already have financing lined up. It prevents you from falling in love with a car that’s out of your price range and allows you to focus your search on vehicles you know you can realistically afford. Pre-approval also speeds up the financing process at the dealership, since the lender has already vetted your information.

To get pre-approved, you submit a loan application with details on your income, debts, assets, down payment amount, and other financial information. The lender then provides a loan offer outlining your maximum loan amount, interest rate, and monthly payments. This offer is good for a set time period, usually 30-60 days. Having a pre-approval letter in hand lets you know exactly how much you can spend ahead of time.


Factors That Determine Loan Amount

When applying for an auto loan, lenders will assess several key factors to determine how much they are willing to lend you:


  • Your credit score and history – Your credit score gives lenders an indication of how reliably you have repaid debts in the past. The higher your score, the more likely you’ll qualify for lower rates and higher loan amounts.
  • Income level – Lenders want to ensure your income is sufficient to make the monthly payments. They’ll verify your income through pay stubs, tax returns, or other documentation.
  • Existing debts – Too much existing debt compared to your income will make lenders less willing to approve high loan amounts. Your debt-to-income ratio is an important factor.
  • Down payment amount – The more money you put down upfront, the less risk for the lender. Large down payments allow you to qualify for more financing.


As a general guideline, your total monthly car payment, including principal, interest, insurance and other costs, should not exceed 25% of your gross monthly income. Many lenders also won’t approve loans worth more than 125% of the car’s value.

Knowing these key factors and ranges gives you a better sense of how much you can realistically borrow for your next auto purchase.


What Impacts Your Interest Rates?

Interest rates can vary dramatically between borrowers. Generally, the higher your credit score, the lower your interest rate will be. Your credit history is one of the biggest factors lenders look at when determining rates.

Lenders want to see a long track record of on-time payments and responsible credit usage. The higher your score, the less risky they perceive you to be. Borrowers with excellent credit (scores above 720) will qualify for the lowest rates.

Conversely, if you have a poor credit score, limited credit history, or past issues like late payments, you’ll be seen as higher risk. This results in you paying a higher interest rate to offset that risk.

In addition to your credit profile, other key factors that influence auto loan interest rates include:


  • The length of your loan term – longer terms generally have higher rates
  • Your income level – higher incomes may qualify for lower rates
  • Size of your down payment – larger down payments reduce risk for the lender


Carefully considering all these factors allows you to get a sense of what interest rate range you may qualify for.


Key Auto Loan Terms and Conditions

To understand exactly how your auto loan works, you need to review the specific terms and conditions, including:


  • The loan amount (principal)
  • Interest rate
  • Length of repayment term
  • Total interest costs over the loan term
  • Whether the rate is fixed or variable
  • Required down payment


Knowing these key details allows you to accurately calculate your monthly payments and total cost of financing.

The loan amount, also known as the principal, is the total amount you are borrowing to purchase the vehicle. This will likely be tens of thousands of dollars for most car buyers.

The interest rate is the percentage cost of borrowing the money, usually shown as an annual rate. Rates can range from under 2% for excellent credit up to over 20% for subprime borrowers. Even small differences in rates can really add up over the long run.

The length of the repayment term is how long you have to pay back the loan, typically 24 to 84 months. Longer terms mean lower payments but greater interest costs over time.

Knowing the total interest costs over the full loan term is key. This shows how much extra you’ll be paying above the original principal to borrow the money.

Auto loans can have fixed or variable interest rates. Fixed rates stay the same over the entire loan. Variable rates fluctuate up and down with market conditions.

The required down payment is the upfront amount you must pay yourself when purchasing the vehicle. Lenders usually require 10-20% down.


How Monthly Payments Are Calculated

When you take out an auto loan, the monthly payment amount is determined based on several factors:


  • The loan amount (principal)
  • Length of the repayment term
  • Interest rate on the loan


Your lender will use a mathematical formula to calculate your exact monthly payment. Here is the basic formula:

Monthly Payment = [Loan Amount x Interest Rate x (1 + Interest Rate)Term] / [(1 + Interest Rate)Term – 1]

Let’s break this formula down into an example:

You take out a $20,000 auto loan at 5% interest over 5 years (60 months). Here is what the calculation would look like:

Monthly Payment = [$20,000 x 0.05 x (1 + 0.05)60] / [(1 + 0.05)60 – 1]

After you calculate this out, the monthly payment comes out to $377.42.

As you can see, with a higher loan amount, longer repayment term, or higher interest rate, your monthly payments will go up. Here are a few more examples:


  • A $10,000 loan at 3% interest over 3 years would equal a $295 monthly payment
  • A $30,000 loan at 7% interest over 6 years would equal a $554 monthly payment
  • A $15,000 loan at 4% interest over 4 years would equal a $339 monthly payment


Use this formula to get an accurate estimate of what your monthly payments will be based on your specific auto loan details.


The Benefits of Auto Loans

Financing your car purchase with an auto loan offers several advantages:


Pay Off Over Time in Installments

One of the biggest benefits of an auto loan is the ability to spread out the total cost of your vehicle over several years. Rather than paying the full amount upfront in cash, you can make more affordable monthly payments over a set repayment term. This helps free up money in your budget compared to paying thousands all at once.


Build Your Credit History and Score

Making consistent on-time payments on an auto loan is a great way to establish or build your credit profile. Your payment history gets reported to the credit bureaus each month. This demonstrates you can responsibly manage debt and improves your credit score over time.


Access Lower Interest Rates

Well-qualified borrowers with good credit can often qualify for lower interest rates with auto loans versus other financing options like credit cards or personal loans. The interest rate has a major impact on your total borrowing costs. Even a couple percentage points can save you hundreds or thousands over the life of the loan.


Purchase More Expensive Vehicles

Very few people can afford to pay cash upfront for newer cars or luxury vehicles. An auto loan allows you to buy a more expensive car than you could pay for out-of-pocket. While you’ll pay interest charges, you get to enjoy driving the nicer vehicle right away.


The Potential Downsides of Auto Loans

However, auto loans also come with risks, such as:


Paying More Overall with Interest Charges

The interest charges on an auto loan mean you end up paying significantly more over the full loan term than the original purchase price of the vehicle. Especially with loans lasting 5-6 years, the total interest costs can really add up.


Higher Monthly Payments Than Expected

It’s easy to only focus on getting approved for a certain loan amount when shopping for a car. But you need to carefully consider whether the monthly payment fits within your budget. Too high of a payment can strain your finances.


Being “Upside-Down” on Car Loans

If your loan balance is higher than the actual resale value of your car, you’re “upside-down” or “underwater” on the loan. This makes it very difficult to sell or trade-in the car if needed.


Repossession if You Default

Failure to make your monthly payments could lead the lender to repossess your car. This severely damages your credit and leaves you without a vehicle.


Stretching Your Budget Too Thin

While it may seem affordable initially, the ongoing auto loan payment reduces the funds you have available for other expenses. This can make it harder to cover bills, savings goals, and other needs.


Alternatives to Auto Loans

While an auto loan is a popular option for financing a vehicle purchase, there are some alternatives worth considering:


Paying with Cash

If you have enough savings, you can avoid finance charges by purchasing your vehicle outright in cash. This allows you to buy the car you want without taking on debt or paying interest costs over time.


Using Manufacturer Financing

Many automakers offer low-interest financing promotions directly to customers through partnerships with lending institutions. This can provide subsidized rates but often requires purchasing specific makes/models.


Peer-to-Peer Lending

You may be able to secure a personal loan with better terms by borrowing from an individual investor through a peer-to-peer lending platform rather than a traditional financial institution.


Leasing Instead of Financing

With a lease, you only pay for the vehicle’s depreciation during your contract term and return the car at the end. This often provides lower monthly payments but you won’t own the car when finished.


Tips for Getting the Best Auto Loan

When it comes to getting the most favorable auto loan, it pays to come prepared and do your homework. Here are some key tips for securing the best rate and terms on your next auto loan:


Check credit reports and scores first – Before even starting the loan process, pull your credit reports from Equifax and TransUnion and examine your credit scores closely. Knowing your credit standing will determine the rates and offers you qualify for. Work to improve any issues beforehand.


Compare rates from multiple lenders – Don’t just accept the first loan offer you receive. Shop around with banks, credit unions, and dealerships and compare all rates and terms side-by-side. Even small differences in APR can save you thousands.


Calculate payments beforehand – Use an auto loan calculator to estimate monthly payments based on factors like loan amount, APR, and repayment term. This helps you budget wisely and avoid too high of payments.


Negotiate terms – Dealers often markup rates offered by lenders. Don’t be afraid to negotiate a lower APR or better terms on your dealer-arranged financing.


Make larger down payment – The more money you put down upfront, the lower your loan amount will be, saving on interest costs. Put down 20% or more if you can swing it.


Auto Loan Options From Dealers vs Banks

When it comes to getting an auto loan, you have two main options – going through the car dealership or getting financing directly from a bank or credit union. Both routes have their own unique pros and cons to weigh.


Dealership Financing

The convenience of having your salesperson handle the financing paperwork can be appealing. Many dealerships also offer manufacturer incentives when you finance through them. However, dealership interest rates are often higher, and they make money by marking up the interest rate above what the actual lender charges. This is called the dealer reserve or “dealer bump” and acts as an extra hidden fee.


Bank/Credit Union Loans

Banks and credit unions will generally offer lower interest rates because they don’t charge the dealer fees. You also have the ability to compare rates from multiple lenders when you shop around independently. Just be aware that you’ll have to handle all the paperwork and approval process yourself, which can be time-consuming.

To get the best deal, consider getting pre-approved with a bank or credit union first, then negotiate with dealers using that rate as leverage. This puts you in a stronger bargaining position. Just make sure to carefully compare the final paperwork to ensure no dealer reserve fees were snuck in.


Protecting Your Financial Health

When financing a vehicle purchase, it’s important to take steps to protect your financial health:


– Don’t overextend your budget with payments. Only take on loan payments you can comfortably afford based on your income and expenses. Going beyond your means puts you at risk of missing payments or defaulting on the loan.

– Read all loan terms carefully before signing. Make sure you understand the interest rate, total interest costs, fees, loan length, and payment amount so there are no surprises down the road.

– Build an emergency fund for repairs. Cars inevitably need maintenance and repairs. Having savings set aside means you won’t have to rely on credit and go further into debt when those expenses pop up.

– Make your payments on time every month. Setting up autopay can help avoid missed or late payments, which would damage your credit score and lead to penalties from the lender.


Following these tips when financing a car purchase will keep your budget intact, credit score strong, and prevent you from getting in over your head. Don’t let the excitement of a new vehicle blind you from making smart financial decisions.



Getting an auto loan can be a complex process, but understanding how they work is key to making the right financing decision for your situation.

To recap, auto loans allow you to spread out the cost of buying a car over several years by borrowing the money upfront and making monthly payments over a set repayment term. Interest rates, loan amounts, and terms vary based on your credit score, income, and other factors.

When applying, shop around with banks, credit unions, and dealerships to compare offers. Getting pre-approved first gives you leverage when negotiating. Carefully calculate monthly payments, interest costs, loan terms, and your budget to avoid overextending yourself.

To get the best auto loan, focus on improving your credit score, minimizing loan length, making a larger down payment, and negotiating the lowest interest rate possible. Avoid costly extras rolled into your financing at dealerships.

While auto loans make vehicles more affordable, use caution when borrowing to avoid financial struggles down the road. Evaluate all your options, run the numbers thoroughly, and borrow only what you can realistically repay.

By educating yourself on how auto loans work and shopping smart, you can finance your next car purchase smoothly and affordably.

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Questions About How Car Loans Work

In Canada, car loans allow you to borrow money from a lender to purchase a vehicle. The car acts as collateral for the loan. You’ll make monthly payments over a set repayment term to pay back the amount borrowed plus interest. Key factors that determine your car loan terms and rates include your credit score, down payment amount, loan length, vehicle details, and lender.

Common car loan terms in Canada are 24, 36, 48, 60, 72, and 84 months (2 to 7 years). 36 and 48 months (3-4 years) are most popular, balancing affordability of payments with faster loan repayment. Longer terms like 60+ months have lower monthly costs but pay more interest and take longer to repay. Choose the shortest term you can afford.

Average car loan interest rates from banks in Canada range between 3.99% to 7.99% for new vehicles and 4.99% to 8.99% for used vehicles, depending on your credit rating. Rates are typically lowest for borrowers with excellent credit (720+ credit score). Compare rates from multiple Canadian lenders to find the best rate.

Canadian car loans charge simple interest that’s pre-calculated, so part of your payment goes towards interest charges first before principal. Interest accrues daily based on your rate, but is calculated monthly based on your outstanding loan balance. This front-loaded interest structure means you pay more interest early on.


While 0 down car loans in Canada are available, a 20% down payment is recommended to get better rates and terms. Putting down less than 20% leads to higher rates since the loan amount is larger. Save up an adequate down payment before getting a car loan to improve affordability.

To get approved for car financing from a bank in Canada and get better rates, a minimum credit score of 650-700 is recommended, although requirements vary by lender. Scores below 600 make approval difficult. Excellent credit scores (720+) qualify you for the lowest advertised interest rates.

Yes, getting auto financing in Canada on disability/pension income is possible with proof of fixed income payments. Fewer mainstream lenders service these niche loans, so seek out specialists like Wheels Financial, Driving Force Financial, or Canada Drives for bad credit, disability, and pensioner car loans.

With a car lease in Canada, you pay only for vehicle depreciation plus interest over the lease term (2-4 years). Monthly payments are lower than loan payments on the same car. At lease-end, you return the car instead of keeping ownership. Leasing costs more in the long run but works well if you want a new car frequently.


Financing is better if you want to keep the car longer term (after loan repayment) or drive high annual mileage. Leasing has lower monthly costs and lets you switch cars more often, but you pay more overall and face mileage limits. Weigh the pros and cons before deciding to lease vs. finance your next car in Canada.

The most affordable car loans typically come from online lenders, credit unions, and manufacturer captives. Compare rates from Fairstone Financial, Coast Capital Savings, Canadian Tire Financial Services, and Ford Credit Canada to save money on interest charges. Avoid high-rate subprime lenders and “buy here pay here” dealers.

Common fees charged on Canadian car loans include application/documentation fees ($75-$500+), optional credit insurance (life, disability), lien registration fee (~$20-60), and prepayment penalties if you pay off the loan early. Ask lenders to detail all rates and fees upfront to avoid surprises.


While you technically can trade-in your car at any time in Canada after financing, waiting at least 12 months (or halfway through your loan term) is recommended. This establishes enough equity to roll over into the new loan and avoid going “upside down” on the loan balance vs car value.

When applying for car loan financing in Canada, have these documents ready for lenders: valid Canadian driver’s license, proof of income (recent pay stubs/tax returns), proof of address (utility bill), list of assets/liabilities, car details (VIN, mileage etc.), and down payment source.

Getting a car loan as a new immigrant in Canada can be challenging but is possible in some cases with a valid work permit, proof of local income/job offer, Canadian bank account history, at least 1 year of credit history in Canada, and a decent down payment. Interest rates may be higher.

The main factors determining car loan eligibility in Canada are your credit score/history, income level and stability, existing debt levels and payment history, down payment amount, loan-to-value ratio on vehicle, length of residence/citizenship status for foreigners, and personal details like age and marital status.

Tips to improve your car loan approval odds in Canada include maintaining a 700+ credit score, keeping debt levels below 40% of income, sticking to a reasonable loan term, putting down at least 20% as down payment, providing proof of stable income from employment, and showing ties to Canada like home ownership.

Defaulting on your Canadian auto loan leads to serious consequences like vehicle repossession, negative impact on your credit rating, getting taken to court by the lender, garnished wages, seizure of assets, deficiency judgment if sale proceeds don’t cover loan balance, and difficulty qualifying for future loans for 7+ years.

The best places to shop for auto financing in Canada are major banks (RBC, TD, Scotiabank, CIBC, BMO), online lenders (Fairstone, Loans Canada, Borrowell), credit unions (Coast Capital, Vancity), and manufacturer captive financing arms (Ford Credit Canada, Toyota Credit Canada).

Car loan options for students in Canada include student lines of credit from banks, secured loans using GICs as collateral through Credit Unions, cosigned loans with parents/relatives with good credit, loans subsidized by manufacturer incentives, and specialist student auto financing from lenders like Auto Credit Express (ACE) Canada.

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