How An Auto Loan Works

The dictionary defines a loan as “a thing that is borrowed, especially a sum of money that is expected to be paid back with interest.” Let’s look at some auto loan basics you’ll need to know:

  • Financing – A common term for lending. Someone can apply for financing directly – from banks, credit unions, or private lenders – or indirectly through a dealership.
  • Interest – The money you pay for using money that was lent to you. A major factor in determining interest rates is your credit score. The lower your score, the higher your interest rate and the more you’ll end up paying over the course of your loan.
  • Term – This is the amount of time you have to pay back your loan. When it comes to auto loans, it’s measured in months – typically ranging from 36- to 72-month terms. Lately, longer-term loans have become popular in auto financing, but this may not be the best idea and it could end up costing you more.
  • Down Payment – This is the initial payment which is made to lower the amount financed. A down payment is usually required for an auto loan if you have bad credit. The amount you invest upfront will save you money over the term of your loan.

Lengths Influence Monthly Car Payments

The length of your car loan also plays a huge role in determining your payment. Monthly car payments can be found by dividing the loan amount by the loan term, while factoring in interest.

Choosing a shorter loan term allows you to pay off your vehicle faster and pay less overall due to lower interest charges. The trade-off is that a shorter loan comes with a higher monthly payment.

At the same time, extending your loan term will give you lower monthly payments in exchange for a higher overall cost due to increased interest charges. In addition to making the loan more expensive, a long-term loan also costs you future flexibility. One risk of a lengthy loan is you’ll owe more than the car is worth, especially during the first few years, which makes it very difficult to sell or trade in your vehicle, and can cause problems if it’s wrecked or stolen.

Extending the loan term to 72 months or more to make a monthly payment affordable only increases the risk that a loan will become seriously delinquent – especially if you have bad credit. The best plan to follow is to choose an affordable vehicle, put down a sizeable down payment and finance it for the shortest term possible – preferably 48 months or less.

Upside Down Graphic for Car Loan

Important tips for an early payoff.

Paying a loan down early can save you thousands in interest charges. Interest is accrued every day based on the amount of principal left on the loan. The quicker the loan gets paid, the more money you save.

Early loan payoff that don’t involve any changes to your loan:

  1. Split your monthly payment – By dividing your monthly payment in half and making a payment every two weeks, you’ll actually end up paying 13 full payments each year.
  2. Round up your payments – Upping the amount you pay – even just $20 a month – can help you pay off your loan months earlier than planned and save in interest charges.
  3. Make extra payments – There’s no hard and fast rule that says you have to stick to a schedule when you pay ahead on your loan. Just pay whatever extra money you can and it’ll help reduce your principal.
Chrysler going to the Sunset

Plan for Your Monthly Car Payment

A more well-rounded approach to buying a car is a budget that considers both the total cost you’ll pay alongside a monthly payment amount you can afford.

One budgeting tip that many car buying authorities recommend is to not use more than 15 to 20 percent of your monthly income for your entire car-related budget. This includes expenses in addition to your monthly payment, such as car insurance, fuel, and maintenance. Factoring in these other expenses of car ownership will give you a much better picture of what you can actually afford.

At the same time, this budgeting tip isn’t meant to steer you toward a longer loan term to get these expenses under 20 percent of your income. It’s supposed to give you a better idea of a price range that realistically fits your budget.

In addition to only considering vehicles that you can really afford, you can keep your monthly car payment in check by having a down payment. Putting money down on a car will reduce the amount of your loan, which will knock down your monthly payment amount and make it easier for you to keep the term short and sweet.

Question of Subprime Financing

What can borrowers do to prepare for a subprime auto loan? We have the following tips:

Check your credit.
Earlier, the young man who reached out to us mentioned that his credit was “not the best.” When you work with a subprime lender, they will do everything possible to get you approved. At the same time, the circumstances that caused your current credit situation will affect the kind of loan terms a lender can offer to you.

Find out what documents the lender will need.
Before you meet with the dealer/lender, be sure that you have all the documents they will typically need to process your loan application. These are the basics:

  • A valid driver’s license
  • 18 years of age or older
  • A legal resident of the United States or Canada (typical minimum is 6 months)
  • Proof of employment and income (paycheck stubs, employer contact information)
  • Proof of residence (such as a utility bill)
  • Personal reference list

There may be other things you will need to do in order to satisfy a lender’s requirements, such as having a down payment or a cosigner.