The Insider Guide To How Car Loans Work

by | Oct 20, 2020

Most Americans simply can not afford to pay out of pocket for a vehicle. As the popularity of the vehicle increased in the mid 20th century, car manufacturers devised a way to sell vehicles to those who couldn’t outright afford them. 

And thus the modern auto loan was born! In doing this, they significantly increased demand and were then able to charge more money for vehicles. A win-win for the vehicle manufacturer and the finance company, not so much for you the consumer. 

So what is an auto loan? An auto loan is where you borrow money to cover the massive expense of buying a new car. Conventionally an auto loan is taken out through a dealership, bank, or third party lender. You agree to an interest rate, down payment amount, and payback period and they agree to loan you the money you need. Before we begin, let’s break down these terms

Terms To Know

Here are some common terms that you are bound to come across as you make the preparations for financing a car. 

  • Annual Percentage Rate– Also referred to as APR, this is the rate at which the interest you owe on your loan will be repaid. So essentially this is how much it is going to cost you to get the loan. The percentage is calculated yearly and the interest is typically compounding. 
  • Down Payment– The down payment is how much money you paid upfront for your car in cash. Don’t make the mistake of assuming this goes to the dealership. The car is paid for in full by your financier, it is they who get the down payment. Down payments are typically required for most loans unless you are buying at a sign and drive style event. The down payment can come in the form of cash or your old vehicle’s trade-in value.
  • Loan Term– This may also be referred to as the duration of your loan. This is how many months you are on the hook for paying off your debt. The length of the loan determines, along with APR, how much your monthly payments will be. 
  • Monthly Payment– This is simply how much you are going to pay back to your lender every month. Part of this will go towards reducing your principal amount and part will be paid as interest. 
  • Principal– This is the amount of your actual loan. It is the sheer amount that you borrowed and does not include the total cost of fees, and interest. 
  • Total Cost– This is how much the entire borrowing process costs you including the principal amount, fees, penalties, and interest. 

When we’re shopping for a vehicle we will spend months picking out the exact car we are interested in down to the color, features and entertainment packages we want. Unfortunately the financing of the vehicle tends to be a bit of an afterthought, and it really shouldn’t be. 

An important tidbit to consider when shopping around for a vehicle and considering financing, is that just because a lender is offering a lower monthly payment, doesn’t mean that you are necessarily saving money. There are a few factors that determine how much you end up paying for a car in total over the life of a loan they are:

  • Quantity of the loan being taken out
  • Length of the loan term
  • Annual Percentage Rate

Amount Of The Loan

This is the total amount that you are borrowing in total. It is not a reflection of how much you will pay in return and it is different than how much you bought your car for. 

Most auto loans require a down payment which can sometimes come in the form of a trade in car, RV or boat, most commonly this is a cash down payment. In some cases dealerships run deals where you put no money down up front. Remember that whatever you put down is money that you are not paying interest on. 

Real world example: If you are buying a car with a $20,000 price tag, you are getting a 4% APR and the length of the term is 48 months (4 years). If you were to put NO money down on this vehicle you would spend $452/ month on that $20,000 loan. Over the life of the loan this would put the total spend in repayment and interest at $21,696. If we were to put down just $2000, the monthly payments would drop to $406 per month. In total over the life of that loan in repayment and interest $19,448. So a net savings in interest of $248 over the life of the loan. 

Length Of The Loan Term

The longer the loan is drawn out for the more money the consumer ends up spending on interest. Sure you may see a lower monthly payment and if your budget is a bit trim this can be a great option, but again, don’t mistake a lower monthly payment when paired with a longer loan term as saving money. You’re paying more money, you’re just getting more time to pay it. 

Real-world example:  If you are buying a car with a $20,000 price tag, you are getting a 4% APR and the length of the term is 48 months (4 years). Let’s say the down payment was $2,000 making the total amount of the loan $18,000. 

Now we’ll compare loan term lengths of 1,3 and 5 years. 

1 Year: For a 12-month loan, you’re going to pay a hefty $1,533 per month in repayment to total $18,392 so overall $392 in total interest for the loan. 

3 Years: For a 36-month loan, you’re going to pay $531 per month in repayment to total $19,132 so overall $1,132 in total interest for the loan

5 Years: For a 60-month loan, you’re going to pay $331 per month in repayment to total $19,890 so overall $1,890 in total interest for the loan. 

Annual Percentage Rate

The annual percentage rate, also referred to as the APR is the effective interest rate that you will pay out on the remaining balance of your loan each month. The bigger your principal amount (this is just the total amount of your loan) the more in interest you will pay each month. 

How Interest Works With Any Loan: Let’s say you take out a loan for $100 due to be paid back in 12 monthly installments over the span of a year. Your APR is 4%. 

Your payments are calculated as the principle amount of $100 divided by 12. In addition to this $8.33 that you get in principle monthly payments there will be compounding interest included in your standard monthly payment. This will reduce as the principle amount decreases. 

The second month, a little less of your monthly payment will go towards interest. In total you’ll pay $2 in interest. Monthly payments do not decrease month to month. For this loan you will pay $9 for all 12 months. 

Real world example:  You are buying a car with a $20,000 price tag, and the length of the term is 48 months (4 years). Let’s say the down payment was $2,000 making the total amount of the loan $18,000. Now we’ll compare the difference in what you will pay with interest rates of 3%, 6% and 10%. 

3% APR: The total cost of your $18,000 loan when you’ve finished out your 48 payments is $19,124. Your monthly payment will be $398

6% APR: The total cost of your $18,000 loan when you’ve finished out your 48 payments is $20,291. Your monthly payment will be $423

9% APR: The total cost of your $18,000 loan when you’ve finished out your 48 payments is $21,504. Your monthly payment will be $448

As you can see, a smaller interest rate can make a huge difference in the realm of saving money when buying a car. This savings is scalable when you take out a loan larger or smaller than the amount listed above. 

If you are looking to run the numbers yourself you should check out a loan calculator. The one I really like a lot is through Bank Of America. Here is the link: https://www.bankofamerica.com/auto-loans/auto-loan-calculator/

 Where To Get A Car Loan

There are several ways you can attain a car loan and it is generally a great idea to shop around and evaluate different financing options. Your options will depend on a couple of things. Your credit score is a big one. Lenders will also evaluate your income levels and how much debt you already have. If you have a good credit score you can go a couple of conventional lending routes:

  • Take out an auto loan through a bank
  • Take out an auto loan through a credit union
  • Take out an auto loan through dealer financing

How Do Car Loans Work Through A Bank?

Borrowing from a bank when buying a car is a similar process to borrowing for things like houses. The bank is going to look at your financial credibility including your credit score and any other information they currently have. This is generally a favorable option for those who already have a good relationship with their bank. Because you are borrowing directly from the bank it can be advantageous if they have a business relationship with you

How Do Car Loans Work Through A Credit Union 

When borrowing from a credit union, you will find mainly the same process as borrowing through a bank with a slight variation that some credit unions will take a more personal approach to banking. What this means is that they (in some cases) will look at alternative credit sources if they are unable to approve a loan with your current credit score.

Alternative credit is essentially handing over your financial statements for the lender to see what monthly payments you have been consistently making that were not recorded by the credit bureaus. 

How Do Dealer Financed Loans Work?

Dealer financing is when you get your loan through the dealership. In these situations the dealer is not the direct lender but a middle man between the lender and borrower. What’s nice about this is that its a one stop shop. You don’t have to bring your financing with you, you just buy the car, give them your information, discuss terms, wait for approval, sign and drive. 

Things To Remember About Financing A Car

  1. Anytime you finance anything, it adds to the overall cost of what you are buying
  2. You can refinance your car at any time

How To Save Money On A Car Loan

Understanding how loans work is essential to know how to go about saving money on a car loan. It can be really tricky for those of us not in finance. You may think that because a dealership is offering you a lower monthly payment that is your most cost-effective option and that is not always the case. The lending offers you will receive will be totally dependent on your credit and financial history. 

Here are ways to save money no matter who you are or what your interest rate looks like. 

Understand What You Can Afford: By designing a payment plan for yourself that you can afford it will help you save money. Understanding how much liquid cash you have helps your money work for you, instead of the other way around. Once you know what you can afford, you can pick the car and financing that is best for your situation. (See below on picking the best loan for you)

Shop Around: You usually don’t want to accept the first offer you are given, both when buying a car and when choosing a lender. By getting options you are doing a couple of things for yourself, first is getting insight on a reasonable interest rate for your financial situation. The second is getting lots of options to choose from. You should consider taking this approach to getting car insurance as well. When comparing policies, cars and loans be sure to do your research and always read the fine print. 

Put Down A Bigger Down Payment: The less money you are actually borrowing, the less money you are paying interest on. Now, this isn’t always feasible for all situations. If you have the liquid funds you are better off spending upfront to avoid the interest. Remember: it is in your best interest to avoid paying interest. 

Make Larger Payments: You don’t always need to simply make your minimum payments. If you feel inclined to do so, add an extra $50 or $100 to your monthly payment when you can afford it. You will be shocked by how much more quickly you are able to pay off your debt. The faster you pay off your loan, the less overall money you will spend on interest. Before doing this, be sure to call your financier and discuss how this will impact their reporting to the credit bureaus. 

Refinance Your Loan: Remember that you can refinance your loan at any time if you think you are eligible for a lower interest rate or need a different monthly payment. Refinancing a loan is similar to taking out a new loan. Your financial situation will be assessed again and your credit run. It’s sort of like trading in your car, you’re essentially trading in your loan and you will be locking yourself into a whole new contract. See more information on this below. 

Choosing The Best Loan For You

Depending on who you are and what your personal financial situation looks like, the best loan for you will vary. Your best bet is to do as much research as possible making sure you understand car loans in and out. Once you fully grasp the process in detail,  you can start  shopping around for the best deals. 

If you are someone with a lot of high interest debt: Your best bet is going with a lower monthly payment so that you can dedicate more liquid cash to paying off debt that is accruing more interest. 

If you are someone trying to build your credit score: stretch out your loan into a longer period. This will give you a lower monthly payment and more opportunities to pay your bill on time. Put down a big down payment to decrease your debt to income ratio and pump that extra money into putting the rest of your debt on minimum payments, or taking out new lines of credit. 

If you are not hurting for money: If you have a large, positive cash flow every month and you are looking for the most cost-effective way to buy a vehicle then you should get the shortest term possible with the lowest interest rate that you can find. Put down a fat down payment and start taking big chips out of that loan every month. 

Refinancing Your Car Loan

If you are currently in a loan for a vehicle, you may want to consider refinancing that loan. Refinancing is essentially taking out a new loan in replacement of the one you already have. When you refinance, your credit will be run and your financial situation will be evaluated again. 

This is great news if you got your loan before getting a raise at work or a new job. If you have paid off a substantial amount of debt you will also likely see a lower interest rate. Depending on your new debt to income ratio and your credit score you can end up getting a much better interest rate

How Does Your Loan Affect Your Car insurance

Well, since you are not technically the owner of your full car until you have paid for all of it, you may find that you need a more comprehensive insurance policy. This means if you crash the car or it gets totalled by a falling tree, you are not the only one suffering a loss. 

Because they have no control over the way the car is being driven, where it is being parked and just natural events, lenders tend to protect themselves by requiring heavy insurance coverage. There are two types of insurance, collision and comprehensive. 

Collision insurance is going to cover you for the standard car accident, though depending on your policy you may only be insured for the damage you do to someone else. Typically a lender is going to require that you maintain a certain level of coverage under this area which will protect the car. 

The other type of insurance is called comprehensive insurance. Comprehensive insurance will cover you for all sorts of things from hail or a hurricane, to flooding, and flying pigs. Even theft and vandalism can be covered under a comprehensive insurance policy. Depending on what kind of a car you own, you may or may not want that much coverage. Unfortunately the lien holder is also usually included to your policy to ensure you are holding up your end of the bargain. 

Consider also buying gap coverage for your vehicle. Say you bought a new car and your loan is a pretty hefty amount. Now you’ve had that car for a few years and the value has decreased significantly for whatever reason. You may be upside down on your vehicle! This is where you owe more than the car is actually worth. 

So what happens if this car is stolen or totalled. If you have comprehensive insurance, your insurer is going to pay out whatever the cash value is on the car. In these somewhat rare cases where a person is upside down on the vehicle, they’re going to be paying out more to dissolve their loan than what they were paid out as an insurance settlement. This is where gap insurance comes in. 

With gap insurance, you will be covered for the gap between the cash insurance payout and the amount you owe on your loan. Of course, if you can avoid it it is best to keep yourself out of this situation to begin with. 

PMC is now offering insurance!

On average, you can save between 15 and 25 percent and in several cases as much as  50 percent on your auto insurance. With the rising cost of insurance today, it’s important to have an agent who is experienced, knowledgeable, and dedicated to helping you find the most discounts and the best coverage available for all your insurance needs to protect your most valuable investments.

Our agents are dedicated and will continue to find you the best rate available at the time of your renewal. So if you are tired of paying high insurance rates or simply just can’t find the time to shop around, give us a call to speak to one of our licensed professional insurance agents to receive a free no-obligation, no-pressure quote.

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Resources:

https://www.bankofamerica.com/auto-loans/how-car-loans-work/
https://www.policygenius.com/loans/how-do-car-loans-work/
https://www.caranddriver.com/research/a31187523/how-do-car-loans-work/
https://www.badcredit.org/how-to/how-does-an-auto-loan-work/
https://www.daveramsey.com/blog/dont-let-your-car-loan-own-you
https://www.consumer.ftc.gov/articles/0056-financing-or-leasing-car
https://www.bankofamerica.com/auto-loans/financing-car/
https://www.bankofamerica.com/auto-loans/auto-loan-calculator/
https://www.experian.com/blogs/ask-experian/is-it-better-to-finance-a-car-through-a-bank-or-dealership/
https://www.investopedia.com/articles/personal-finance/070915/personal-loans-vs-car-loans-how-they-differ.asp
https://www.experian.com/blogs/ask-experian/how-does-financing-a-car-work/
https://www.moneyunder30.com/how-to-finance-a-car-the-smart-way

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