Discover How Car Loans Work [A Guide]
Purchasing a car is a big financial move. Unless you have a great deal of money saved up, you’ll likely find yourself needing to apply for a car loan.
Understanding how this major purchase will affect your finances for the next three years and more is important as you embark on a journey of car ownership. It can seem complicated, but it doesn’t have to be. We’ve created this guide to help you understand your car loan and get the best deal for your money.
Important Factors of How Car Loans Work
You’ll probably hear a few terms a lot when shopping for a car loan. Here are some straightforward explanations to help you speak the language of car loans.
APR
APR is the “Annual Percentage Rate” for a car loan. This figure includes the total amount you will have to pay to borrow money. It is different from the “interest rate” in that it includes all the costs incurred by taking out a loan. Fees, interest, etc. It’s all included in the APR.
Principal
Principal is the amount of money you are borrowing, before interest. If you are borrowing $10,000, you will pay more than that after all is said and done, but $10,000 is still the principal.
Terms
The loan “terms” are basically the terms and conditions of borrowing the money. A big feature of the terms is the repayment period – which is sometimes called the “term.” This can get confusing, so watch out for the difference.
Monthly payments
How much you pay each month is a combination of the APR, principal, and terms. When you’re shopping for a car loan, it’s important to consider all of the above.
What Determines the Car Loans You Can Qualify For?
What car loans you can qualify for depends heavily on your credit score. It also depends a bit on whether you are purchasing a new or used car. The difference between excellent credit (750+) and poor credit (450-600) can mean a difference of more than 10% for your APR.
So, if you’re planning to get a car loan in the future, the best thing you can do is try to build your credit as much as possible.
Choosing a Car Loan
The first steps to choosing a car loan are setting a budget and determining your down payment. You should endeavor to put down 20% of your car’s total cost at purchase, if possible. After calculating a down payment, you can start to figure out how much you will want to pay each month towards your car.
It’s vital to know how much you can budget each month to put toward a car loan. Creating an honest monthly budget and tracking for a few months to see if you can stick to it is a great way to figure out how much you can really afford to pay.
Choosing a car loan can seem difficult, but the best thing to do is shop around so you can weigh all of your options. For example, a low APR but long term may result in paying more in the end as the principal accumulates interest for more time. On the other hand, a short term can mean high monthly payments which you might not be able to afford.
The best way to compare car loans is to use an auto loan calculator. This allows you to make sense of how the slightly varied APR, terms, and repayment periods will impact your pocket.
How Car Loan Interest Works
When you start shopping for a car loan, you’ll probably hear about “front-loaded” interest. This refers to the fact that at the beginning of a standard loan, you have a higher principal that you are paying interest on. So, you’ll pay most of the interest at the beginning of the loan’s life. Over time as you make payments, the principal shrinks, and along with it the interest you pay.
Some loans have “precomputed” interest. If this is the case with your loan, the total interest is calculated at the beginning of the loan and divided over the months that you will pay it back.
Shopping For Car Loans
Many credit unions, banks, and dealerships offer car loans. The deals you can get are different in each case though.
Banks
Many banks offer a wide range of car loans, but they typically have higher interest rates than credit unions.
Dealerships
Dealerships sometimes offer special deals to customers buying at particular times of the year or shopping for particular cars. These can be deals that even offer 0% APR for some time! However, it’s always important to make sure that a deal you’re getting from a car dealer is actually a deal and not a sales mechanism. Again, use a calculator.
If there are no special promotions, dealer rates are usually not as good as you can get at a bank or credit union.
Credit unions
Credit unions are financial institutions that are owned by the members. They’re not for profit, which means they don’t have to hike up APR to increase profits. They often offer excellent APR for members.
Switching Up Your Car Loan
If you have a car loan, but you’ve since realized that you aren’t happy with its terms, don’t worry – there’s always refinancing.
Figuring out when and how to refinance can be tricky. Click below for more information on deciding if refinancing your car loan is worth it for you.