How Do Car Loans Work and Where to Get One

how-do-car-loans-work-fi

In the United States, most people can’t afford to buy new vehicles outright. Consumers throughout the country pay for 85% of new cars and 53% of used cars with auto loans.

Car loans are now the third biggest form of debt in the country, and it’s still on the rise. Before getting your dream car, it’s essential to determine the answer to this question:

How do car loans work?

If you don’t understand the implications of getting a car loan, you might end up paying hefty interest fees or leaving an ugly mark on your credit score.

We’ve put together an essential guide to car loans — what they are, how they work, types of loans, and where to get one. Read on to learn everything you need to get your dream car.

 

What Are Car Loans?

Car loans — also known as automobile or auto loans — refer to borrowing money from a lender to purchase a car. As with other loans, borrowers have to pay back the money with fees and interest by a set date.

Let’s familiarize ourselves with a few terms you’ll come across when looking for loan options.

  • Principal - The principal is the original amount borrowers agreed to pay back. For example, if you take out a $20,000 loan, the principal is $20,000.
  • Annual Percentage Rate - The annual percentage rate (APR) refers to the yearly interest rate lenders charge borrowers. This rate includes fees and additional costs associated with car loans. The higher the APR, the more expensive your loan payments become.
  • Down Payment - The down payment is an upfront settlement toward the total cost of a vehicle. You can pay this amount in cash, a trade in, or a combination of both, which lowers the total amount of your car loan. Some merchants nowadays offer seemingly friendly car deals that don’t require down payments. It may seem like a smart choice to grab such deals, but they may cost you substantial amounts of interest. If you have enough cash to make a down payment, do it. Your future self will thank you later
  • Interest Rate - The interest rate is the percentage charged to borrowers for their car loans. However, some factors will affect your interest rate, including: credit score, down payment amount, loan term. You should understand how your lender computes the interest on your loan to know where your monthly payments go. It will affect the amount you pay the lender monthly.
  • Loan Term - Apart from thinking about how much you can afford to spend monthly on your car, it’s also important to consider how long you want to make loan payments. In most cases, car loans last between three to six years. Keep in mind that choosing a longer loan term can lead to higher interest rates.
  • Monthly Payment - The monthly payment is the amount the borrower pays the lender each month. It includes the principal amount, plus interest and other fees.

 

How Do Car Loans Work?

Borrowers typically pay lenders back through monthly payments. The amount of these payments depends on the principal, loan term, and interest rate.

Car loans have two portions: the principal and the interest, plus any add-ons.

 

In most cases, longer-term loans like 72-month ones can reduce monthly payments but grow the total loan cost. If individuals don’t explore their car loan options, they might end up owing lenders exorbitant amounts more than their car’s worth.

 

Many people find lower monthly payments attractive, but they’re not always worth it.

Let’s compare a $30,000 loan at a 4.00% interest rate under different loan terms. The figures don’t include sales taxes.

 

Loan Term

Monthly Payment

Total Interest

4 years (48 months)

$677

$2,514

6 years (72 months)

$469

$3,769

 

As the example shows, lower monthly payments for a six-year loan term leads to a higher total interest. Even though the four-year time frame has a higher monthly payment, choosing that option allows the borrower to save $1,255 on interest fees.

Apart from lower monthly fees, these are other factors that may affect your finances:

  • A lower principal: If you can lower your principal amount, do it. You can make a bigger down payment or trade in a used vehicle to do this.
  • A lower APR: Without other considerations, a small change in the APR can lead to massive annual savings. If given a chance, go for a lower APR.
  • A longer loan term: Like the example above, a longer loan term means lower monthly payments but more interest throughout the loan’s life.

 

Types of Car Loans

Now that we’ve discussed car loans and how they work, let’s delve deeper into six common types.

 

Secured Car Loans

In most cases, car loans fall under this category.

With secured car loans, borrowers have security over the vehicle. This agreement means that if a borrower can’t repay the loan, the lender can seize, repossess, or sell the asset to recover his money.

The lien lifts as soon as the borrower pays the loan off.

This type of car loan reduces risks for lenders, which means borrowers can get a lower interest rate from other car loan types. However, keep in mind that other facts like credit score and loan term may affect interest rates.

 

Unsecured Car Loans

With this car loan type, the underlying asset does not secure the loan.

 

Unsecured loans don’t permit lenders to place liens on the vehicles financed with loans, so they can’t repossess the assets even when borrowers fail to pay their debt.

 

The greater lender risk of unsecured loans causes them to have higher interest rates than their secured counterparts. As with secured loans, other factors like credit profile may affect interest rates.

 

Simple Interest Car Loans

Simple interest car loans often save borrowers money because of their structure.

With these loan types, the parties compute the interest charges based on the principal amount. They offer more flexibility for the borrowers because they can accelerate the payoff and limit interest fees by making payments toward the principal amount.

We recommend these loans for individuals with substantial savings or those expecting an increased cash flow.

 

Pre-Computed Car Loans

Unlike simple interest car loans, pre-computed loans don’t offer the same level of flexibility to borrowers. They use a rule of 78s to calculate interest charges, favoring lenders for short-term loans.

With these loan types, borrowers should schedule payments on a predetermined basis. Each one has a fixed amount going toward the principal and interest.

Advanced payments in these loans don’t affect the principal and interest figures; they instead front-load the payoff.

We recommend this loan type for borrowers with a limited budget or those who expect a dip in their financial future.

 

Lease Buyout Loans

Lease buyout loans are not as popular as the other types discussed earlier, but it’s still worth learning about them.

These loans provide borrowers with a chance at full ownership of their vehicles after their lease terms.

Here’s how they work: The lender pays the lease buyout fee, which the borrower can pay monthly over a fixed term. The lien lifts as soon as the borrower pays the loan’s principal.

 

Title Loans

Title loans are secured loans reserved for individuals who purchased their vehicles outright. They work like a home equity loan where the title enables the borrower to get a loan against the car’s value.

Upon issuance of the loan, the lender places a lien on the vehicle and takes the title. While the borrower keeps the car, the lender can repossess it if the former becomes delinquent.

 

Where to Get a Car Loan

There are two ways to get a car loan: direct lending or dealer financing. As with any loan, we recommend getting different quotes to find the best deal for you.

 

Direct Lending

Credit unions, banks, online lenders, and more, fall under the direct lending category. Borrowing from these institutions gives people a chance to look for the best loan terms.

Individuals with good records with these direct lenders can help them secure better rates. Getting a loan from these institutions often costs less because there are no middlemen overseeing transactions.

 

Dealership Financing

This car loan option provides maximum convenience for borrowers because they can shop for vehicles and auto loans from one shop. Dealers often have tie-ups with several lenders, providing consumers with many options.

In these settings, dealerships act as the middlemen, which might lead to higher costs for buyers.

 

Car Loan Requirements

In most cases, borrowers need to complete an application form with information about their financial stability.

Some information questionnaires often ask include:

  • Social Security number
  • Address
  • Employment information
  • Income Sources
  • Information on debt

The approval process often includes checking credit scores. As long as buyers compare loan options within a short time frame, it shouldn’t affect their credit scores by much.

 

Frequently Asked Questions

Let’s go through some of the questions our clients often ask us about car loans.

  • What Is the Required Minimum Monthly Income for Car Loans? There is no required minimum monthly income for car loans, and different lending institutions often have varying requirements. However, most companies accept loans from individuals with at least $1,500 monthly income before taxes.
  • What Is the Required Score for Car Loans? There’s also no universally accepted score for car loans. However, lenders usually look for prime borrowers, those with scores of 661 and higher.
  • Where Do Car Down Payments Go? Car down payments go toward the vehicle’s total purchase price. Once you pay the loan in full, the ownership transfers to you.
  • Is Getting a Car Loan a Bad Idea? No, it’s not a bad idea. It does have its pros and cons, but it helps most Americans who can’t afford to buy vehicles outright. The downside of getting a car loan is that borrowers have to pay interest and other fees. The best way to handle loans is to find the lender who best suits your needs.
  • What Is a Good Down Payment for a Car? Putting at least 20% down on a new car will drastically lower the principal, interest rates, and monthly payments on a loan. For a used car, 10% should be okay. If you won’t deplete your savings to make a down payment for a car, we recommend doing it.

 

Get Your Dream Car Now

If you’re looking for a reliable credit union around Jacksonville, 121 Financial Credit Union is ideal for you. We’ve been serving our community’s financial service needs for 85 years and counting.

Three factors set us apart from the competition: knowledgeable staff, affordable prices, and excellent services.

We offer low-interest vehicle loans from any dealership in town. Check our rates now to discover just how competitive our prices are.

If you are looking to refinance your auto loan, we may help you lower your interest rate, decrease your monthly payments, or even pay off your auto loan sooner.

We can’t wait to help you buy your dream car!

Back to Blog

Related Articles

How to Get a Car Loan With No Credit History or Bad Credit

Credit is vital when making large purchases and big financial decisions.  Big-ticket items like a...

How to Refinance a Car Loan: A Step by Step Guide

Refinancing a car loan is a great way to pay off an auto loan quickly. But, is refinancing the...

Financing a Boat: How Do Boat Loans Work

For some people, nothing compares to the freedom of sailing the seas or the peace of fishing at...