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Auto finance 101: How do car loans work?

  • Cars Explained
  • Renee Martin
  • 5 minutes

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For most of us, it’s pretty much impossible to buy a brand-new car outright. Fortunately, several lenders could help you out by offering car loans. But how do car loans work?

Car loans function by providing you with a lump sum of money to help you purchase a car. To obtain a car loan, you must first apply and get authorized by a lender. You can apply at a bank, a credit union, an online lender, or a car dealership. While that’s the gist of how a car loan works, several other factors go behind obtaining a car loan. Let’s take a look.

How does a down payment affect your car loan?

A down payment is the amount of money you can pay for your new vehicle out of pocket, and the more you can come up with, the better off you will be. Your loan will be for the amount you need to borrow, minus your down payment.

While you may be tempted to buy a new or used car with no down payment, we strongly advise against it. Although car dealers are ready to overlook a down payment, this could cost you a lot in interest.

For instance, if you are considering a $45,000 vehicle and have $5,000 to put down, you will need a loan for the remaining $40,000. As a result, the larger your down payment, the lower your principal will be. The bigger the down payment, the lower your overall monthly payment would be.

Furthermore, many car buyers will opt for auto refinance shortly after purchasing it. You may be able to receive a better deal from another lender if you do so. This could save you a lot of money on your monthly payment. If your credit score has improved since you took out your auto loan, refinancing may be advantageous.

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Once you’ve paid for your new car with your car loan, it is yours to drive. However, you need to make monthly loan payments, with interest, over time. The lender maintains the title to the car until you fully repay the loan. If you fall behind on payments, your lender could repossess your car at will.

Tip: Apply to numerous lenders and compare offers to ensure you get the best loan possible. Don’t rely only on the dealership for your car loan when rates and costs may be higher.

How long should your car loan term be?

Getting a car loan isn’t simply about how much money you have each month. It would be best if you also thought about how long you want to make these monthly payments. A car loan term is the length of time it will take you to repay the money you owe to the lender. These terms can range from three to six years long, although they can also be longer or shorter based on your needs.

The duration of your car loan is typically stated in months, such as 36 months or 72 months. Car loan terms used to be significantly shorter, but as the cost of new cars rose, lenders have increased the length of car loan terms. It is fairly common to see contracts lasting 60 to 72 months. A shorter car loan term will result in bigger payments. Thus, a longer car loan term could be better for your finances in the long run.

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However, it comes with its downsides too. Extending your loan lowers your monthly payment. But it does increase the amount of interest you pay over time. This means that a 60-month term could cost you hundreds of dollars more in interest by the time you pay it off completely. It is also important to keep your car’s rate of depreciation in mind while deciding on the conditions of your car loan.

Longer loans are generally riskier for lenders. This will reflect in your interest rate. As a result, obtaining the shortest loan terms feasible is always recommended.

How are interest rates calculated?

When buying a new car with a car loan, it is important to understand an interest rate and how it will affect your auto loan. An interest rate is the percentage of principal charged by the lender on the money you’ve borrowed. The principal is the total amount borrowed. If you owe $30,000, the lender will calculate your interest rate based on this amount. This is how lenders make a profit while covering their costs. Lenders will determine your interest rate depending on several factors such as:

  • Credit rating
  • Credit history
  • Loan duration
  • Down payment
  • Make and model of your car

Interest rate calculations using either a simple or precomputed calculation. Simple interest depends on the amount you owe when your car loan payment is due. So, the interest you owe could drop if you pay more than the due amount each month. Precomputed interest, on the other hand, calculates interest in advance. With this form of calculation, paying more will not reduce the amount you pay in interest.

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Understanding how your interest rate gets calculated will help you understand where your monthly payments are going. You can then consider whether paying more each month will benefit you regarding the total amount of interest you pay. Or else, you could consider an auto refinance to save a bit of money.

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