Instead of paying tens of thousands of dollars up front for a vehicle, an auto loan helps people borrow money to purchase a vehicle and breaks the cost up into more manageable monthly payments.
Buyers can apply for a loan through a lending institution or directly through the car dealership. There are different terms available for auto loans (typically 3-6 years) and once the balance is paid at the end of the term, the buyer will own the vehicle outright.
Almost all auto loans are simple interest loans.
This means that in addition to the principal (amount borrowed), the borrower will also pay interest on the principal.
Interest is what the lender charges you to borrow the money. The interest amount is expressed as a percentage of the principal amount.
This differs from the type of loan you would have with a credit card, which is based on compounded interest. Compound interest loans involve the lender collecting interest not only on the premium, but also on accumulated interest from previous periods.
Auto loans have interest rates that are typically far lower than credit card interest rates. This is because auto loans are considered a "secured" loan, meaning that the vehicle being financed is used as collateral (i.e., if you fail to pay of your auto loan, your vehicle may be seized to recoupe some of the money owed).
Car loan lingo can be confusing, and many people assume that the APR (annual percentage rate) and the interest rate refer to the same number. In reality, these two numbers have some slight, but important differences, and typically the APR is the larger of the two numbers.
Interest Rate - the cost of borrowing money, expressed as a percentage of the amount borrowed.
APR - the true cost of borrowing money, which includes not only the interest rate, but also any other fees to borrow money, still expressed as a percentage.
Lenders are required to share both numbers with you, so be sure to look at the APR as well as the interest rates when comparing offers.
There are four primary factors that determine your auto loan interest rate.
If you do not have enough of a credit history, it is possible to secure an auto loan in two other ways.
1. By providing a substantial down payment (to show lenders your committment to paying of the purchase).
2. By adding a cosigner to your loan. This is generally a family member or close friend who has established credit and a good score.
Learn more about your FICO credit score & car buying here
Getting an auto loan for a used car IS possible, but the interest rates will always be higher than a new car auto loan.
New cars have less wear-and-tear and are usually under factory warranty for the majority or even entirety of the loan term. This means that there is less risk for the lender since the buyer isn’t as likely to experience expensive out of pocket repairs that would impede their ability to make timely loan payments.
Generally, used cars that are no older than 6 or 7 model years and with less than 80,000 miles can be financed with an auto loan. And shorter term loans can often be found for vehicles older than that.
The benefits of a down payment is that it lowers the amount of money you will need to borrow, makes it easier to get a loan, offsets depreciation, and also leads to lower interest rates and potentially, a shorter lease term.
A down payment proves your committment to paying off the loan, so lenders reward buyers who provide down payments with easier approval and lower rates to borrow money. For borrowers with a credit score less than 600, a down payment may be required. Remember, even though it is possible to finance a car completely, without any money down, no down payment will likely make interest rates higher.
Most dealerships recommend 5-10% down payment and financial advisors generally recommend a 20% down payment on new cars, but the actual amount required is largely up to personal investing preferences and lender requirements.
A down payment can be in the form of a trade-in vehicle, cash, check, debit card, and even paypal.
In March 2020, the average car loan period reached an all-time high of 70.6 months. While 3-5 years auto loan periods used to be the norm, longer loan lengths have been trending in recent years.
Borrowers are typically able to choose from 24 to 84 month payment periods. There are many pros and cons to both short and long-term lease periods.
Our general advice for loan terms is to pick the shortest term that you can reasonably afford.
Short Term Loans: Higher monthly payments. Lower interest rates. Own your car out-right without monthly payments sooner.
Long Term Loans: Lower monthly payments. Higher interest rates than short term. Takes longer to own your car outright. Must keep up with pay-
In the video below, learn to manually calculate your monthly payments. You will need to know the price of the vehicle, the loan length, interest rate, and what your down payment is.