What is a car loan and how does it work?

What is a car loan?

A car loan is a form of consumer credit used to buy a vehicle, new or used, repaid in monthly instalments¹. It finances the car price minus your down payment and usually has lower rates and longer terms than a personal loan, because the car itself acts as security: the bank typically keeps the reserva de propriedade (title to the car) until the loan is paid off.

The feature that most sets it apart from a personal loan is the option to include a residual value: a larger final payment, kept until the end of the contract, that lowers the instalment during the loan but must be paid (or refinanced) at the end.

Down payment and residual value: what moves the payment

Two factors specific to a car loan change the payment:

• The down payment is the part of the price you pay yourself. You only finance the price minus the down payment, so a bigger down payment reduces the balance, the payment and the total interest.
• The residual value is a slice of the financing kept until the end. During the loan the payment only amortises the difference, which makes it lower; at the end you pay that amount in one go. A higher residual lowers the monthly payment but raises the total interest, because the capital stays outstanding for longer.

How the payment is calculated

The payment is constant and follows the French amortisation system: each month part of the payment covers the interest on the outstanding balance and the rest repays capital, down to the residual value at the end. The formula is:

payment = (financed − residual ÷ (1 + i)^n) × i / (1 − (1 + i)^−n)

where i is the monthly rate (the TAN divided by 12) and n is the number of months. With a zero residual the bracket equals the financed amount and the formula reduces to a fully-amortising loan.

TAN, TAEG and the real cost of credit

They are two different rates, and confusing them is the most common mistake:

• The TAN (nominal annual rate) is the interest rate that drives the payment. It is the one in the formula above.
• The TAEG (the APR) is the one that measures the real cost: it bundles the interest and every charge of the credit, such as the arrangement fee, the monthly commissions, the associated insurance and stamp duty².

That is why the TAEG is always higher than the TAN. It is the TAEG, not the TAN, that you should use to compare offers from different banks. For a detailed look at what the TAEG includes, see what the TAEG is.

How much does it cost? (worked example)

Imagine a €25,000 car with a €5,000 down payment (financing €20,000) over 60 months (5 years), at an 8.5% TAN and a €4,000 residual value:

• The payment is about €356.60 a month. That is lower than the €410.33 you would pay without a residual, but at the end you still owe the €4,000 balloon.
• Over the loan you would pay about €25,396 (including the final balloon), of which about €5,396 is interest.
• The TAEG would be 8.84% (the TAN compounded monthly, since there are no fees in this example).

Run the numbers with your own figures in the car loan calculator, which shows the payment, the final balloon, the TAEG and the total cost, or compare it with a personal loan with no residual value.

Loan, leasing or renting?

Buying a car on credit is not the only route, and the products are easily confused:

• With a car loan, the car is yours from the start (with the bank holding title until it is paid off) and it remains yours at the end.
• With leasing, you pay to use the car for a term and have a purchase option at the end (you pay the residual value to keep it).
• With renting, you pay a monthly fee that bundles services such as insurance and maintenance and hand the car back at the end, without buying it.

This calculator covers the car loan. Leasing and renting are distinct products, with their own tax and contractual rules.

What to check before signing

Before you sign, the bank gives you the standardised information sheet (FINE), which brings together the TAN, the TAEG, the fees, the insurance and the total amount payable (everything you will pay). Use it to compare, and keep in mind that:

• Banco de Portugal publishes, every quarter, the maximum rates (TAEG) that can be charged on each type of consumer credit¹. An offer above that cap is illegal.
• You have 14 days to withdraw from the contract (the right of free withdrawal), with no need to give a reason.
• You can repay early, with a fee capped by law.

A car loan is a useful tool when the car is necessary and the payment fits comfortably in your budget. Always compare by the TAEG, plan for the residual value if there is one, and choose the shortest term you can pay without straining your finances.