What you need to know about auto loans
Buying a car can be complex. The first step is determining how much you can afford and how much you want to borrow. It comes down to your budget, preferences, and the total cost of purchasing a car. It is important to balance your needs and wants so you don't borrow more than you can afford.
The annual percentage rate (APR) tells you the annual cost of your auto loan. Your loan rate is expressed as a percentage, like an interest rate. It generally includes all the costs associated with your loan, such as recurring and one-time fees.
How much car can you afford?
Everyone's budget is different, but one rule of thumb is to keep your monthly car payment at 15% or below your income after taxes. You should keep in mind the total cost of buying a car not only includes the monthly loan payment, but includes any sales tax, cost of insurance, gas, annual registration fees, and maintenance and repairs. Parking may also be an additional expense.
For example, if your salary is $50,000 a year, 15% would be $7,500 a year or $625 a month. Based on your location, driving history, car type, and other factors, your monthly auto expenses may be:
- Car payment: $300
- Auto insurance: $90
- Maintenance: $50
- Fuel: $60
- Total monthly cost of car ownership: $500
You can get an insurance quote before you purchase the car and check the gas mileage to estimate your costs. After you have done your research, know how much you can afford and what type of car to buy, the next step is to shop around for the best auto loans.
Get your auto loan pre-approved
Before stepping on to the car lot, get a prequalified or pre-approved loan first. This can give you leverage when it comes to negotiating. Dealerships will try to offer you financing, but may not offer the best rate. You will also know how much car you can buy. The temptation to upgrade to the latest bells and whistles may be high, so having the pre-approval amount beforehand can help you stay within your budget.
Dealers tend to take people with a pre-approved loan more seriously since they know they are ready to purchase a car as opposed to someone who is just window shopping. Many financial institutions or lending platforms will approve your loan on the same day you apply.
When applying for an auto loan, you will typically need to provide the lender your salary and employment information, the amount you want to borrow, and your housing information. The lender will check your credit score. Your approval and interest rate will depend largely on your credit score and history. If you have bad credit, you can offset the higher cost of a loan with a larger down payment or a shorter loan term.
Since vehicle price is also considered, the terms will vary depending on the vehicle you choose. It is important to know that when financial institutions advertise low interest rates, it is typically for those with the best credit scores.
Once you start applying for auto loans to find the best rates, the lenders will conduct a hard inquiry on your credit report which will hurt your score.
However, if you apply for loans within a two-week period, the credit bureaus will count them all as one inquiry. You should time your applications and apply with different lenders during this two-week period.
Balance your loan terms with your budget
Typically, the longer your auto loan term, the higher your interest rate. Getting a shorter-term loan will mean you pay less interest, but the monthly payment amount will be higher. Look at your budget to find an affordable monthly payment that balances the financing costs.
Some financial institutions will allow you to roll up any sales tax, title, registration, or even warranty charges into the car loan. This will increase your loan payment. Be careful that your loan doesn't become "upside down." With extra costs rolled into the loan, you could owe more than what the car is worth.
Your final loan amount will depend on the purchase price of the car, minus the total down payment you make, and the cash value of your current car if you plan on selling it or trading it in. Here is more information about these terms.
Trade-in value
The value of your current vehicle will be subtracted from the price of your next car. The dealership is essentially buying your car from you. The trade-in value is typically less than selling it on the private market.
Down payment
You can choose to pay as much or as little in advance as you want. The more you put down, the less you have to borrow, potentially lowering your monthly payment. Some lenders will require a minimum down payment, depending on the car.
Loan term
This is the length of time you take to repay your loan. This affects your APR and how much interest accrues over its lifetime. A shorter loan term could reduce your costs in the long run, but it will likely raise your monthly payments. Loan terms depend on the bank or credit union. They are generally 36 months, 48 months, 60 months, and 72 months. Some financial institutions offer loan terms as long as 84 months or seven years.
Equity
This is the value of your car after any outstanding debt is subtracted. If you owe $5,000 on a $10,000 car, then your equity is $5,000. The amount of equity you have in your car can affect your refinance rate. Some lenders will not allow you to refinance a vehicle if your equity is too low.
Different types of auto loans
The rates will depend on the type of auto loan you get. New car loans are typically for brand new cars or cars under a certain mileage or car year. A used car loan is for a used car below a certain year or above a certain number of miles. Used car loans generally have the highest interest rate due to depreciation and lower prices than new cars. Used cars may also have more mechanical problems.
If you already have an auto loan, you can refinance your car to get a lower interest rate. Refinance loans usually have the lowest interest rates. It makes sense to refinance your car if you had bad credit when you purchased it and since then, your credit score has improved. Some lenders will not refinance a car that is too old, over a certain mileage, or below a certain value.
The last thing used for an auto loan is to buy out a car lease. A lease buyout loan gives you the ability to buy your currently leased car. You can use the loan to buy your car at the end or before the end of your lease.
Your car is collateral
An auto loan is a type of secured loan. If you default on your loan, the lender will repossess the car as collateral. It will then try to sell the car to recoup its losses. Because an auto loan is a secured loan, they offer better rates than unsecured loans such as a personal loan or credit card. If you sell the car or trade it in for an upgrade, you will have to pay back the balance left on the loan.
It is common for people to buy more car than they need. Once you check your budget to find the optimal total cost you can afford, do your research and shop around to find the best auto loans. Online banks and credit unions generally have better rates than brick-and-mortar banks. By getting a pre-approved loan, you can find the best rate available and you will have better negotiating power with the dealer.
