How Do Car Loans Work?

By 2017, over 107 million Americans had a car loan. Car loans can be very useful for people who need a new vehicle, yet their income doesn’t allow them to get one on spot. Before you decide to get your own car loan, it’s best to know what to expect from one. This is why we prepared this article for you – it contains useful details regarding car loans, how they work and whether they’re a good option or not.

What Is a Car Loan?

A car loan is a sum of money someone borrows from a lender to purchase a new car. When you don’t have enough funds to buy a car, you can go to a specialized lender and get a loan. This will allow you to buy the vehicle you desire.

But how do car loans work? Similar to a secured loan, a car loan also needs collateral. While secured loans allow you to use different types of things as security for the loan, a car loan will secure the car you want to buy. This means that if you are not making repayments towards your loan, the lender has every right to take away your vehicle. Basically, the lender is the one retaining ownership over your vehicle until you’re able to pay the last penny.

As for the payment, you need to make fixed installment payments over time, which will slowly pay off the amount borrowed. Since there is something to secure the loan, the interest rate is not as high as it is for unsecured loans. Overall, it’s a less risky loan for the lender.

Car Loan Terms

If you want to know how these loans work, then you have to understand some of the key terms related to car loans before getting the actual loan. If you know all these details, then you can make an informed decision and get an amazing loan that benefits you and won’t feel like a burden. Below, we’ll take a look at some factors that will affect the amount you have to pay back overall and how much you’ll pay in monthly installments:

Down Payment

The down payment refers to the amount of money you can spend for the car out of your own pocket, and not from the loan you’re borrowing. When you make a down payment but also need a car loan, the loan will be taken out on the amount of cash you need to borrow, minus the down payment you can make.

That being said, you can use a down payment or not, depending on your situation. Some car dealers will allow you to obtain a loan without a down payment. However, while you could only use a loan to purchase the vehicle, no down payment means you would have to pay more in interest.

For instance, if the car you want costs $30,000, but you only have $10,000, you can use your money as a down payment, and then only get a loan for the remaining $20,000. Without a down payment, more interest will be charged and, on top of that, the monthly payment is going to be much higher.

Interest Rate

An interest rate is a percentage that the lender will charge on the amount of money you’ve borrowed. No matter how much the loan is – the interest rate will be based on that particular amount. This percentage is used to cover the costs for the lender, but also help them make a profit. This is how lenders can make money.

There are a few things taken into consideration when the lender is calculating your interest rate, respectively your loan term, credit history, credit score, down payment, and vehicle type.

An interest rate can be calculated through simple or precomputed calculations. Simple interest refers to the amount of cash you owe when the car loan payment is due. This means that the interest amount could become smaller if you pay more than the required amount every month. Precomputed interest is calculated in advance, meaning that your interest amount is not going to decrease if you pay more. Knowing how your particular interest is calculated will allow you to understand why you have to pay a certain amount every month.

Loan Term

A loan term refers to how long you will have to make payments for. To be more specific, a loan term is how much time you will have to spend paying the money you owe to your lender. Depending on the loan, the terms can go from a few months to a few years.

Auto loans will usually require 36 or 72 months to pay off, especially since car prices have increased. In general, car loan terms will be fixed at 36, 48, 60, or 72 months.

How a Down Payment Affects Your Loan

As mentioned earlier, a down payment could help you pay less interest and less money to the lender every month. Not making a down payment is possible, yet it will instantly mean you have to pay a higher amount every month, and the interest rate will go up. If you have part of the amount necessary for repaying a loan, using it as a down payment is a wiser decision.

How Much Does a Car Loan Cost?

The cost of a car loan depends on the price of your chosen vehicle, and how much you can pay as down payment, as well as the interest rate set by the lender.

That being said, let’s say the vehicle costs $35,000. You only have $5,000, and you use it as a down payment. That would make your loan $30,000. This amount is the principal amount of the loan. Then, the lender will calculate the interest rate based on the factors we mentioned earlier. The credit score you have will influence the interest too. The lower your credit score, the higher the APR is going to be.

Because of the interest rate added to the amount, you will end up paying more than the amount you borrowed by the end of the loan term.

How to Save Money on a Car Loan?

Do you want to save money on your car loan? Here are a few ways to do so:

• Round Up the Payments: When you make payments, round up to the closest hundred dollars and pay more. This will save in interest and will make sure you pay off the loan faster.
• Make Extra Payments: If you receive some extra money, use it towards your loan and make an additional payment for the year.
• Refinance to Lower Rates: You can refinance if you can find a lower interest rate and secure it.

Personal Loan vs. a Car Loan

There are a few key differences between the two types of loans. For instance, a personal loan doesn’t limit the way you use the funds, whereas a car loan is only for purchasing a vehicle. But car loans have lower interest rates compared to personal loans and are much easier to obtain if your credit history is mediocre. The lending requirements are tougher for personal loans, and it’s harder for applicants to qualify.

Conclusion

We hope we offered a comprehensive answer to the question “how do car loans work?” If you’re planning on getting a car loan, make sure you can make a down payment and that you can save money on the loan too – it will make your life much easier.

Frank Gogol

I’m a firm believer that information is the key to financial freedom. On the Stilt Blog, I write about the complex topics — like finance, immigration, and technology — to help immigrants make the most of their lives in the U.S. Our content and brand have been featured in Forbes, TechCrunch, VentureBeat, and more.

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