How Do Car Loans Work? Four Things You Need to Know

Man Driving Car

If you are in the fortunate position of having enough cash on hand to pay for a car outright, this is not the “how-to” guide you need. However, that would also mean your financial good fortune places you in a relatively small group, as approximately 85% of new passenger vehicles are financed.

Car loans are a reality for most Americans at some point in their lives, and have quickly become as common as a student loan or personal loan. Whether it means the purchase of a first car, an upgrade to a larger vehicle when starting a family, or even buying a car for a teenage driver, auto financing has become a part of everyday life.

Because car loans are as likely for most of us as paying rent or a mortgage, filing a tax return, and buying groceries to feed our families, we should all know the basics before entering into such a loan.

A little bit of car loan education goes a long way, preparing us for what lies ahead when we set out on four wheels of our own.

Black Super Car

The Four Things You Need to Know About Car Loans

Understanding how auto loans work means understanding these four components and how they work:

  • Down payments
  • Interest Rates
  • Loan Terms
  • Titles

We will familiarize you with these terms so you know the lingo well before you walk through the dealership doors and also so you can prepare yourself to make the best decision about a car loan.

Car Loan Down Payments

A car loan is an agreement between you (the borrower) and a lending institution/financial institution (the lender) to give you the funds needed to purchase a new auto.

Once you find a financing option that works for you, you’ll settle upon an agreement you will pay the loan back in monthly installments, by a specific date, with interest added.

An influencing factor from the lender’s perspective in the amount of the loan and the required payments and interest rates is how much you may be able to offer in a down payment. In other words, if you have only $500 as a down payment, your loan will be less attractive than if you had $5,000 to put down.

Many people rush into car financing and go in with very little for a down payment. If you are in a position to wait and save more money, that down payment can really help you in the long run, allowing you to pay more upfront and rack up less interest on your auto loan and a smaller car payment over time.

For a long time, the number most associated with down payments was 20%, meaning consumers were advised to put down 20% of the car’s overall price as a down payment.

However, as auto prices have increased, this number has become an impossibility for many. Still, putting down 10 or 15% if possible will help you reduce the monthly payments and secure a better interest rate.

Dollars

Car Loan Interest Rates

If you have ever heard anyone say in a warmer climate “it’s not the heat that will get you, it’s the humidity,” the same concept could be applied to car loan interest rates.

It’s not the sale price of the car that will get you, it’s the interest rate.

To be fair, if the sale price of the car is six figures and you are a college student with a part-time job at a frozen yogurt café, then the sale price will get you, too!

However, the main point here is that a high interest loan over time can really hurt you financially, especially if unexpected circumstances make it difficult for you to make your monthly payments.

Walking into a car dealership as a car buyer means you need to be aware of what you’re getting into when it comes to dealer financing.

Interest rates are how lenders make money, and it is down to the consumer to understand what factors go into determining this rate so that the lenders are not making windfall profits off of your inexperience.

The interest rate on your car loan will be set by the lender after reviewing

  •  Your credit score and history
  • The term of your loan
  • Your down payment
  • The value of vehicle you are purchasing

If you know going into a car loan that at least one of these areas will reflect poorly on you, it helps to bump up your efforts in another. For example, if your credit score was dinged by some financial hardships, you should consider how this will affect your rate.

Bad credit sometimes can’t be helped- it’s best to get a credit report to look at your credit history to get an idea of where you stand. With a lack of excellent credit, perhaps try to save until you can make a down payment of more than 20%.

Car Loan Terms

The loan term of the loan refers to an agreed period of time for you to make your loan payment each month to repay the debt in full. In the case of car loans, the term is usually between 36 and 72 months to pay off your principal balance.

Simple math will tell you the shorter the team, the higher the monthly payment, and vice versa. One thing to bear in mind is while a lower monthly payment probably seems tempting, a longer-term also means you are paying more in interest.

When entering a loan application, car buyers should choose the shortest possible term they can afford in order to avoid overpaying with a higher interest rate.

Women Relaxing in Car

Car Loans and Titles

A final piece of the car loan puzzle borrowers should consider is how the auto title works in conjunction with the money you borrowed. Even though you are the “owner” (as in primary driver) of the vehicle, the lender retains the title until your debt is paid in full. This means the lender can take the car back if you default on the loan.

Once a car loan is paid in full, the title will be transferred to you.

Final Thoughts on Car Loans

By going into the car buying process with a clear idea of the down payment you can afford as well as understanding the terms and interest rates offered, you will be in a better position to negotiate a fair and favorable loan.

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