How Do Auto Loans Work?
5-Minute ReadUPDATED: December 12, 2022
Most people who buy a car need to take out an auto loan to pay for it. That's because cars are expensive: Kelley Blue Book reported that the average transaction price for a new car, van, sport utility vehicle or smaller truck came in at $38,948 in December of 2019.
Most people don't have that much cash to give to an auto dealer. These buyers, then, must finance the purchase of their new car with an auto loan that they pay back over time.
But how does a car loan work? How much will you have to spend each month to pay one back
Here's a look at the basics of auto loans. Understanding how these financial tools work is an important step when you're ready to buy a new car.
How A Car Loan Works
Auto loans are much the same as any other loan: You’ll typically apply with a bank, credit union or other lender. You can also apply for a car loan directly from the dealership where you purchase your new vehicle.
Once you get your loan, you’re responsible for paying back your lender in monthly installments, with interest. The size of these payments will depend on the amount of money you borrow, the number of years of your loan and your interest rate.
Say you take out a $20,000 auto loan with a 60-month term at an interest rate of 2.69%. Your monthly payment would be $357.
If you took out that same loan with a term of 48 months, you'd pay $440 a month.
If you instead took out a car loan of $30,000 with a 60-month term and an interest rate of 3 percent, your monthly payment would rise to $540.
As you can see, your payment can rise and fall significantly depending on your term, interest rate and amount you’re borrowing.
What Do Lenders Look At When You Apply For An Auto Loan?
Lenders will look carefully at your income, debts and credit score when you apply for a loan. The higher your credit score and income and the lower your debts, the more likely it is that lenders will approve your loan request.
Lenders will also pull your three credit reports, one each from the national credit bureaus of Experian™, Equifax® and TransUnion®. These reports will include any recent late or missed payments. Lenders are more likely to work with borrowers who don’t have a history of missed payments. This doesn’t mean you can’t get a car loan if you’ve paid your credit card bill late in the past, but you might get hit with a higher interest rate, making your auto loan more expensive.
Lenders will also look at the price of the car you want to buy. The more expensive your car, the better your credit and income levels must be to qualify for a loan. It’s important to note, too, that loans for used cars typically come with higher interest rates than do those for new cars.
Finally, lenders will look at the length of your loan. If your loan’s term is longer – the more months it will take you to pay it off – lenders might charge you a higher interest rate to make up for the increased risk they’re taking on.
Is A Lower Monthly Payment Always Better?
It's important to remember that a lower monthly car payment doesn't necessarily mean that you'll pay less overall for your loan. That's because of interest.
In general, the longer the term of your loan, the lower your monthly payment will be. That's because your repayment is stretched out over a longer number of months. But you'll pay more in interest if you take out a longer-term loan.
Here's an example: Say you take out a $25,000 auto loan at 3% interest for a term of 48 months. During your 4 years of payments, you'd pay $1,561 in total interest. If you take that same loan at that same interest rate but extend your term to 60 months – 5 years – you'd drop your monthly payment by $104 but you'd increase the amount of interest you'll pay to $1,953.
A shorter-term loan, then, might be a better choice if your budget can handle a higher monthly payment. You’ll pay less for your car by taking out a shorter-term loan.
If your financial situation changes, you can investigate refinancing your auto loan. Be aware, though, that refinancing isn’t free. You’ll have to pay fees, so make sure the reduction in interest rates is worth the costs of a refinance.
Is Financing Your Auto Purchase A Good Idea?
If you have the money, it usually makes more sense to buy a car with cash. With cash, you won’t have to pay interest, which can save you plenty of money.
The only time it makes sense to finance even if you have the cash to buy a car is if you’re disciplined enough to invest the money you would’ve spent on a new car. The key is to invest your money in an interest-bearing account that will earn more than what you’d save by not paying interest on your car loan.
Most people, though, can’t afford to take this approach. For them, financing the purchase of a car is the only option.
Should You Take Out Financing From The Dealer?
When financing a car, you have the option to take out a loan through an outside bank or lender or through the auto dealership itself.
It's a good idea to get a few quotes before deciding on financing. If any lenders offer pre-approval, that can help you understand your price range before you start shopping. During the preapproval process, the lender or bank will run your credit, check your income and determine how much money it is willing to lend you. If you find a car, you’ll be able to use this preapproval letter to initiate a loan to finance the purchase.
You aren’t required to use this loan, though. Your dealer might offer you financing, too. Let your dealer know about your existing loan. The hope is that the dealer will offer you a loan with a lower interest rate and better terms. Financing directly through the dealership could also save you time as they'll handle much of the paperwork themselves, but it may not be the best deal for you.
Explore your options with both dealers and other lenders to get the best deal for your situation.
What Happens If You Miss Payments?
Whatever loan you take out, make your payments on time. If you pay late, you could face a late fee from your lender. And if you make your payment 30 days or more past its due date, your late payment will be reported to the three credit bureaus. This can cause your three-digit FICO® Score to drop by 100 points or more.
If you miss enough payments, your lender can repossess your car, taking it away from you.
Of course, financing your car or paying for it in cash aren’t your only two options. You can also lease a car. Learn whether leasing or buying is better for you.
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