How Do Auto Loans Work?
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Car shopping and borrowing money go hand in hand. About 85% of new car buyers will use some form of financing, according to Experian. For used cars, financing is involved in 55% of these transactions. So whether you are new to car buying and want to know how do auto loans work or could use a financing refresher, read on as we review important information and suggest some car loan hacks.
Car Loans 101
Let’s first go over some car loan basics.
What Is A Car Loan?
You may ask, “How do auto loans work?” A car loan is a legal agreement to borrow money to purchase a vehicle and repay the loan. The lender typically charges interest and requires repayment as monthly installments. The interest rate may vary depending on the amount financed, length of the loan, the vehicle’s age, and your credit rating. Auto loans are secured loans. This means that the car becomes collateral for the loan, and it can be repossessed by the lender if you fail to make on-time payments.
Down Payment:
A down payment is any money you contribute towards the car at the time of purchase and can include any equity from a trade-in. Depending on your credit and income situation, some lenders may require a down payment.
Interest And APR:
The interest rate reflects how much the lender will charge you to borrow money for a set period. The annual percentage rate (APR) reflects the interest rate and any fees associated with the loan so that the APR can be higher than the interest rate.
Terms and Conditions:
The loan document will spell out the lender’s terms and conditions for your loan. Like any legal agreement, it’s essential to understand these requirements before signing loan papers. Typical terms and conditions include:
- Length of loan (in years or months)
- Interest rate/APR
- Repayment requirements
- Insurance and registration requirements
- Penalties for late payments or early payoff of the loan
Equity:
Equity is the value of your vehicle less what is owed on the car’s loan. Negative equity is when you owe more on the car than it’s worth–auto dealers call this being “upside down.” You have positive equity if your vehicle is worth more than you owe on the loan. It’s important to understand vehicle equity as you begin your search for loan options–we’ll highlight equity later on.
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Set A Budget
An important part of learning how do auto loans work involves determining how much you can afford to spend each month on a car. In addition to a monthly loan payment, consider costs for insurance, fuel, and maintenance. At the same, figure out how much money you can set aside for a down payment.
Loan Shopping
The first step in searching for a car loan is checking your credit report and addressing any errors: the higher your score, the more favorable the loan terms. Keep in mind that while numerous loan applications may temporarily reduce your credit score, Experian reports that its system will recognize multiple car loan applications submitted within a 14-day as a single inquiry. So, it’s vital to do all your loan shopping within that time.
Let’s move on to sources for your car loan.
Credit Unions/Banks:
Consider where you do your banking now as a possible lender for your new car. Credit unions and banks may offer a preferred interest rate to an existing customer or offer other special programs. At the same time, be sure to shop around for the best rate, especially among credit unions.
Online:
Many banks offer online loan pre-qualification programs that provide approximate loan terms without performing a hard pull of your credit report. While a formal loan application will more thoroughly review your credit and change a pre-qualified loan offer, this approach can be an ideal way to begin your loan search. Similarly, online loan marketplaces may shop your loan application among several lenders–this may provide pre-qualification terms or a pre-approved loan offer.
Dealers:
A car dealer should be the last place to shop for a loan. Ultimately, this may be where you choose to go for financing, but it’s important to know what your other options are first. Dealers make a lot of money off of vehicle financing, so they are strongly inclined to match or maybe even beat an offer from a competing lending source.
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Important Car Loan Considerations
Let’s look at some car loan hacks that give your greater insight into how do auto loans work.
Avoid Extended-Term Loans:
Lenders will encourage you to take out a car loan with 72- or 84-month term loans. Compared to a 48- or 60-month term loan, the lower monthly payments will be appealing, but you will pay significantly more in interest. For example, a $25,000 loan at 5% interest over 84 months will have a $353 monthly payment. You’ll also pay $4,681 in interest if you keep the loan for the full term. The same loan amount and interest rate will mean a $576 monthly payment over 48 months and a total interest cost of $2,635. That extra three years of payments will cost more than $2,000 in interest.
Additionally, extended-term loans may put you in a negative equity situation liked we talked about earlier. Cars lose the majority of their value during the first five years of ownership. So, if you go trade-in your car halfway through an 84-month loan, it’s possible to find yourself in an upside-down (negative equity) situation.
Low-Interest Loan Vs. Rebate:
If you are considering a new car, dealers may offer a manufacturer incentive that provides a choice of a very low-interest rate (and sometimes a zero percent rate) or a rebate. It might be tempting to jump at a no-interest loan. Let’s explore one example to see if it makes sense.
You’ve selected a car with a final price of $25,000, and the dealer offers you a choice of a zero-interest loan for 60 months (payments would be $417 a month) or a $3,000 rebate that would reduce the price of the car to $22,000 (and use standard financing). You’ve been pre-approved through your credit union for a 60-month loan at 3%. So, taking the rebate and the credit union loan would work out to a lower monthly payment of $395. This reduces your payment and saves you more than $1,300 over the life of the loan. Given a choice, do the math to see what works best.
Negotiate Dealer Financing:
Dealers want to finance your car purchase. As we mentioned, they make money when this happens. Identifying non-dealer financing terms before seeing the dealer’s terms helps in two ways. First, you’ll know for sure that the dealer is offering competitive loan terms. Second, you can negotiate with the dealer to not only match your best outside loan offer but ask them to beat it. A quarter-point reduction in interest or a further decrease in the car’s price will save you money. It never hurts to ask.
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