How do auto loans work?


 

Woman in car purchased with auto loan

 

Buying a car is one of the largest purchases you can make in life, which means researching the right model is usually top priority. While that’s important, so too is understanding the financing. Knowing how auto loans work will help you to find credit that offers best value for your needs.

Auto loan arrangement

An auto loan involves borrowing money from a lender that provides funds to pay for a vehicle up front. The borrower repays the debt in monthly installments, including interest, according to the agreed terms.

Factors that affect an auto loan

Three main factors affect the structure of an auto loan and how much the loan will cost overall.

Loan amount – The amount of money you borrow, known as the principal, is the foundation of the loan and can be reduced by any trade in or down payment you make.

APR – Annual percentage rate is the interest rate charged on the principal and lender’s fees. The higher the APR, the greater your total loan costs.

Loan term – The term sets out how long you will spend repaying the loan and, when loan amount and APR are decided, it will determine your monthly payment. Auto loans are generally 36 to 72 months in length.

How to save money on an auto loan

Here are five ways to lower interest charges and trim the cost of an auto loan.

Borrow less – The less you borrow, the less interest will accrue on your loan. A trade in and down payment are common ways to achieve this, but there are other options, too. Consider negotiating down the price of the car, buying a used vehicle instead of a new one, or opting for a less expensive model.

Get a shorter term – Given a specific loan amount and APR, a shorter term will result in a smaller total interest charge than a longer one. The other effect of a shorter loan is a higher monthly payment, so it’s worth assessing the potential benefit of interest savings versus a payment that fits your budget.

Here’s a case in point. A car shopper is offered a $20,000 loan at 5 percent APR over 72 months. The monthly payment works out at $322 and the total interest charge is $3,191. By shortening the loan to 60 months, the monthly payment rises to $377 but interest falls to $2,646 – a saving of $545 over the life of the contract.

Improve your credit – Credit score is a key factor in most auto lending decisions. You might want to improve your score to increase your chances of approval and a lower rate, especially if you have bad credit.* The Consumer Financial Protection Bureau recommends the following approaches to get and keep a good score:

  • Check your credit reports and dispute any errors you find
  • Catch up with any late or missed credit payments
  • Maintain regular payments
  • Use no more than 30 percent of your total credit limit
  • Only apply for the credit you need

Pay early or extra – The majority of car loans are simple interest loans for which interest is calculated daily. With this type of loan, any early or extra payment reduces the outstanding principal and the amount of interest due. You could, for example, set your payment to be made before the due date, make half your payment twice a month, add to your monthly payment, or pay a lump sum.

Refinance your loan – Another route is to refinance a loan with another lender. When a customer is approved for refinancing, the new lender will pay off the existing note and provide a fresh loan with different terms, such as lower APR. If you didn’t get the best deal first time around, market rates have dropped or your credit has improved, this may be for you.

Where to get financing

There are two main options to get auto financing: through a dealership or directly from the lender.

Indirect lenders – Auto dealers offer customers the convenience of getting their car and financing at the same time. The dealership will use a third party to provide the funds, and may mark up the APR to compensate themselves for their role in the process. The contract, however, is between the customer and dealer.

Direct lenders – Applying for a loan straight from the lender, whether in the branch of a bank or credit union or through an online provider, is a low-pressure way to seek financing. It also enables the customer to visit the dealership preapproved. That may help them to stay within budget and negotiate confidently on the price of their vehicle. A lender such as RoadLoans makes the whole process simple with a short online application, instant decisions and a network of trusted dealerships.

Making the right choice

It’s easy to accept a financing offer when it paves the way to your car purchase. Understanding how auto loans work, however, will provide you with a better idea of whether that loan truly meets your needs. Loan amount, APR and loan duration are all significant factors that influence what kind of car you can afford and how much you’ll pay for your money.

Remember that everyone’s situation is different, and while savings on interest may be the aim for one person, a lower monthly payment at the expense of higher overall costs could be more important for someone else. Use our auto loan calculators to estimate what may work for you, and apply for a loan online.

 

* “Bad” or “poor” credit generally is considered a FICO score around 600 and below by sources including the Consumer Federation of America and National Credit Reporting Association (reported by the Associated Press), Bankrate.com, Credit.com, Investopedia, NerdWallet.com and others. The Congressional Budget Office identifies a FICO score of 620 as the “cutoff” for prime loans. FICO scores are not the sole factor in lending decisions by RoadLoans.com and Santander Consumer USA.

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