How Do Car Loans Work?
JA
Summary:
If you’re like most Americans, you’ll require a car loan to purchase a vehicle. Once you apply and receive loan approval, you’ll need to make a down payment on your car followed by monthly payments. The amount of your monthly payment will differ depending on your interest rate, which is calculated based on your credit score, loan term, and the vehicle purchased.
Many people rely on cars to get them to work, run errands, and go on vacations. But unless you pay for your vehicle in cash, you’ll likely need a loan to finance the purchase. If so, you’re not alone. In 2020, less than 20% of new vehicle purchases were made in cash, leaving the remaining 80% financed through loans or leases.
Despite being such a large part of the automotive industry, auto loans can confuse some car buyers, especially those buying their first cars. In this article, we’ll cover everything you need to know about how car loans work to ensure you’re getting the best deal possible. Let’s start with a look at the basics of car loans and the terminology you need to know before you head to the dealership.
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How does getting a car with a loan work?
Auto loans are a popular way to finance the purchase of a new or used car. But how do they work? In a nutshell, a car loan is a type of installment loan. That means you borrow money and agree to pay it back over a set period of time, usually 36 to 72 months.
The longer the loan term, the lower your monthly payments will be. However, you’ll end up paying more in interest over the loan’s lifetime. This is because, in addition to the principal loan amount you borrowed, you also have to pay interest on the loan.
Car loan interest rates are determined by many factors, including your credit score, the type of vehicle you’re buying, and the length of the loan term. In general, the better your credit score, the lower your interest rate will be. Below you can see the average auto loan interest rates for 48- and 60-month loans.
What happens when your loan is approved?
Once you have been approved for a car loan, you’ll need to make a down payment. The size of your down payment will depend on the dealership and the type of vehicle you’re buying. Many auto loan lenders require a minimum down payment of 10% of the purchase price. But this may vary depending on the specific dealership you work with.
If you’re trading in your old car, the value of the trade-in may be applied to your down payment. Once you’ve made your down payment and signed the loan agreement, the vehicle is yours. From there, you’ll then make monthly payments to the lender until the loan is paid off. Once the loan is paid off, you own the car outright and can do with it as you please.
Key terms to understand
It may help to familiarize yourself with some common car loan terms before you start shopping for a new vehicle. Here are a few key phrases to keep in mind:
Loan term
A loan term is the length of time you have to repay your loan. Car loan terms typically range from 36 to 72 months, but some lenders may offer terms as short as 24 months or as long as 84 months.
Some car buyers prefer longer loan terms, as this lowers their monthly payments. However, it’s important to keep in mind that a longer term means you’ll pay more in interest over the life of the loan.
Principal amount
The principal amount is the total amount of money you borrow, not including interest or other fees. For example, if you borrow $20,000 to buy a car, the principal amount would be $20,000.
Unfortunately, as inflation increases prices, car buyers must borrow more and more money to purchase a vehicle.
Amortization
Amortization is an accounting technique used to lower the cost value of a tangible asset over time. The word “amortization” (which comes from the Latin word for “death”) refers to the process of spreading the cost of an asset evenly over its lifetime.
When an asset is amortized, its cost value is reduced gradually over time until it reaches zero. This process is similar to depreciation. However, whereas depreciation spreads the cost of an asset evenly over its useful life, amortization spreads the cost evenly over the asset’s entire life, including its period of obsolescence.
Down payment
Down payments are often required by lenders to reduce the risk of default. A down payment is typically a percentage of the purchase price of the vehicle, and it may be paid in cash or trade-in value.
The size of the down payment will vary depending on the dealership and the type of vehicle you’re buying. Many lenders require a minimum down payment of 10% of the purchase price. But this may vary depending on the specific dealership you work with, as some dealerships may offer special financing options that allow you to put down less.
Monthly payment
The monthly car payment is the amount you’re required to pay each month over the life of the loan. This amount is determined by the interest rate, the length of the loan, and the principal amount. Your monthly payment may also be affected by any fees or other charges that are applied to the loan.
Annual percentage rate
The annual percentage rate (APR) is the effective rate of interest that is charged on an outstanding loan or credit card balance. It takes into account the interest rate, any fees or other charges that are applied, and the length of time over which the debt is outstanding.
APR is intended to give borrowers a clear understanding of the true cost of borrowing, and it’s generally expressed as a percentage. Make sure to compare APRs when shopping for a new loan so that you get the best deal possible.
How does APR work on car loans?
When you’re shopping for a car loan, APR is one of the key factors to consider. The lower the APR, the less you’ll pay in interest charges over the life of the loan.
When comparing offers from different lenders, be sure to look at the total cost of the loan, not just the monthly payment. Otherwise, you may end up paying more in interest than you intended. Another critical factor to keep in mind is that longer loans tend to have higher APRs.
So, if you’re considering a longer loan term to keep your monthly payments low, you may want to offset that by shopping for a lender with a lower APR.
Where to get a car loan?
Car loans are available from various financial institutions, including banks, credit unions, and online lenders. When shopping for a car loan, it’s essential to compare rates and terms from multiple lenders to ensure you’re getting the best deal. It’s also a good idea to check your credit score beforehand so you know what kind of interest rate you can expect.
Once you’ve found a loan that meets your needs, the next step is to complete a loan application. Be sure to have all the required documentation, including proof of income and identity, before submitting your application.
Pro Tip
Remember that the more loans you apply for, the bigger the hit on your credit score. So, if you’re not sure you’ll be approved, it’s a good idea to check with multiple lenders or ask for them to only conduct “soft credit checks” before applying.
FAQs
Is it worth it to get a car loan?
The answer to this question depends on a number of factors, including the interest rate, the length of the loan, and the amount of money you’re borrowing. In general, car loans are a good idea if you’re able to get a low-interest rate and you’re comfortable with the monthly payments. But if you’re able to pay for the car in cash, that’s usually the best option.
Is it smart to pay off a car loan early?
Yes, it’s usually a good idea to pay off your car loan as soon as you can. This will save you money on interest charges and help you become debt-free more quickly. If you’re able to make extra payments each month, you can even pay off your loan early. Just be sure to check with your lender first to make sure there are no prepayment penalties.
When I pay off my car loan, what happens?
When you pay off your car loan, the lender will send you a lien release document indicating that the loan has been paid in full. You should then receive the title to the vehicle, which will be free and clear of any liens. If you have any questions about the process, be sure to contact your lender.
Key Takeaways
- Understanding how car loans work is crucial if you’re planning to finance a car purchase.
- APR is the yearly cost of borrowing money, including interest charges and other fees. The lower the APR, the less you’ll pay in interest charges over the life of the loan.
- You can get a car loan from banks, credit unions, and online lenders. Before applying for a loan, compare rates and terms from multiple lenders.
- Your monthly payment on a car loan is determined by the interest rate, length of the loan, and amount borrowed. It’s usually a good idea to pay off your car loan as soon as possible to save on interest charges.
- When you pay off your car loan, the lender will send you a satisfaction of lien release, and you should receive the title to the vehicle.
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