How does a car loan work?
Monday, 11 November 2019
Americans love their cars.
In fact, more than 93 percent of U.S. households reported having access to at least one vehicle in 2017. That translates into about 275 million vehicles on American roads between the first quarter of 2017 and the first quarter of 2019.
However, considering the average price of a new vehicle in 2018 was more than $36,000, not many Americans have the cash on hand to buy a vehicle. This explains why more than 85 percent of new vehicles in the U.S. are bought with loans.
Auto loans are fairly simple: you borrow money from a lender, which includes the principal, or the purchase price of the car, plus interest. You make monthly payments until the principal and interest are paid off.
But there are some important details about auto loans you should understand before you start test-driving and filling out loan applications.
Your credit score is a big deal
Not only is it key to getting approved for a loan, but a good credit score can help you get a lower interest rate. On the other hand, you could pay a higher interest rate if you have a low credit score.
So is the interest rate you pay
Basically, interest is the fee a lender charges you to borrow money. A lower rate will save you money, while a higher interest rate could increase how much you pay each month and the total cost of the car. Here's an example:
|Annual Percentage Rate: 3.5%||Annual Percentage Rate: 6.0%|
Amount Borrowed: $30,000
Amount Borrowed: $30,000
Term: 5 years (60 payments)
Term: 5 years (60 payments)
Monthly payment: $546
Monthly payment: $580
Total cost of car loan: $32,745
Total cost of car loan: $34,799
Auto loans use simple interest, which means the interest you pay on your loan is a flat percentage of the amount you borrow. It's calculated upfront and doesn't change.
When you make monthly payments, you pay back interest as well as the principal, which is the amount you borrowed before interest. For the first few years, you make payments, you pay back more interest, while toward the end of your loan, you pay mostly principal.
The loan term is also an important factor
How many years you take to repay your loan affects your monthly payment and how much you pay over the life of your loan. A shorter-term will result in higher monthly payments but a lower overall cost, while a longer-term will lower monthly payments but increase the total amount you pay for your car.
A down payment can make a difference
When you make a down payment — which could be cash or the value of a vehicle you trade-in — you lower the amount you borrow. This could help lower your monthly payments and the total amount you pay as well.
Monthly payments really matter
One of the most important factors to consider when figuring out if you should buy a specific vehicle is whether you can afford the monthly payments. The fastest way to calculate monthly car payments is to use an online calculator.
You can save money by paying your loan off early
Even if you just pay a little extra each month, or make an extra payment each year, you'll reduce the total amount you pay. And, in most cases, there's no penalty for paying your car loan early.
Run the numbers carefully before rolling one car loan into another
It might make sense in the beginning: you're trading in a car and still owe money on it. Why not just roll your current loan into the loan on the new car you're buying? Because it could end up increasing your monthly payments and how much you're paying for the new vehicle. You could even end up owing more on the car than it's worth. Instead, consider selling your car, paying off your current loan and using any leftover funds to make a down payment on a new vehicle.
Not paying your car loan as promised can have dire consequences
As with any loan, if you don't pay it back, you'll damage your credit score, which could prevent you from getting credit for many years to come. What's more, if you don't make your car payments on time every month, you could have your car repossessed. However, if you're just getting started with credit or working on repairing your credit, getting a car loan (possibly with a co-signer) and making your monthly payments can be an excellent way to establish or improve your credit score.
As with most financial transactions, every vehicle-buying situation is different. However, understanding car buying and auto loans can demystify the process and help make purchasing a vehicle a more positive experience for you.
The content provided is for informational purposes only. Neither BBVA USA, nor any of its affiliates, is providing legal, tax, or investment advice. You should consult your legal, tax, or financial consultant about your personal situation. Opinions expressed are those of the author(s) and do not necessarily represent the opinions of BBVA USA or any of its affiliates.
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