Buying a car is one of the largest purchases you can make in life, which means researching the right model is a top priority. So is understanding the financing of the vehicle. Knowing how auto loans work will help you to find credit that offers best value for your needs.
Auto loan arrangement
An auto loan involves borrowing money from a lender that provides funds to pay for a vehicle up front. The borrower repays the debt in monthly installments, including interest, according to the agreed terms.
Factors that affect an auto loan
Three main factors affect the structure of an auto loan and how much the loan will cost overall.
Loan amount – The amount of money you borrow, known as the principal, is the foundation of the loan and can be reduced by any trade in or down payment you make.
APR – Annual percentage rate is the interest rate charged on the principal and lender’s fees. The higher the APR, the greater your total loan costs.
Loan term – The term sets out how long you will spend repaying the loan and, when loan amount and APR are decided, it will determine your monthly payment. Auto loans are generally 36 to 72 months in length.
How to save money on an auto loan
Here are five ways to lower interest charges and trim the cost of an auto loan.
Borrow less – The less you borrow, the less interest will accrue on your loan. A trade-in or down payment are common ways to achieve this, but there are other options too. Consider negotiating down the price of the car, buying a used vehicle instead of a new one, or opting for a less expensive model.
Get a shorter term – Given a specific loan amount and APR, a shorter term will result in a smaller total interest charge than a longer one. The other effect of a shorter loan is a higher monthly payment, so it’s worth assessing the potential benefit of interest savings versus a payment that fits your budget.
Here’s a case in point. A car shopper is offered a $20,000 loan at 5% APR over 72 months. The monthly payment works out at $322, and the total interest charge is $3,191. By shortening the loan to 60 months, the monthly payment rises to $377 but interest falls to $2,646 – a saving of $545 over the life of the contract.
Improve your credit – Credit score is a key factor in most auto lending decisions. You might want to improve your score to increase your chances of approval and a lower rate, especially if you have bad credit.* The Consumer Financial Protection Bureau recommends the following approaches to get and keep a good score:
- Check your credit reports and dispute any errors you find
- Catch up with any late or missed credit payments
- Maintain regular payments
- Use no more than 30% of your total credit limit
- Only apply for the credit you need
Pay early or extra – The majority of car loans are simple interest loans for which interest is calculated daily. With this type of loan, any early or extra payment reduces the outstanding principal and the amount of interest due. You could, for example, set your payment to be made before the due date, make half your payment twice a month, add to your monthly payment or pay a lump sum.
Where to get financing
Getting pre-qualified is a smart, low-pressure way to seek financing that gives you a good idea of whether you’ll get approved for a loan. A lender such as Drive® makes the whole process simple with a short pre-qualification that only takes about two minutes and doesn’t impact your credit score. If you pre-qualify, you can use our Budget Customizer to tailor your financing terms, search for vehicles that match your budget then visit the dealer to shop with confidence.
Making the right choice
It’s easy to accept a financing offer when it paves the way to your car purchase. Understanding how auto loans work, however, will provide you with a better idea of whether that loan really meets your needs. Loan amount, APR and loan duration are all significant factors that influence what kind of car you can afford and how much you’ll pay.
Remember that everyone’s situation is different, and while savings on interest may be the aim for one person, a lower monthly payment at the expense of higher overall costs could be more important for someone else.
* “Bad” or “poor” credit generally is considered a FICO score around 600 and below by sources including the Consumer Federation of America and National Credit Reporting Association (reported by the Associated Press), Bankrate.com, Credit.com, Investopedia, NerdWallet.com and others. The Congressional Budget Office identifies a FICO score of 620 as the “cutoff” for prime loans. FICO scores are not the sole factor in lending decisions by Santander Consumer USA.
