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How do auto loans work?

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When shopping for a car, it’s important to consider more than just the initial cost. If you’re financing the purchase with a loan, whether for a new or used car, you’ll also be paying interest throughout the loan duration.

Your monthly payments won’t solely reduce the purchase price but will also contribute to paying off the interest accrued. Longer loan terms and higher interest rates result in greater overall payments over time.

How auto loans work

The process of obtaining approval for a car loan follows a similar pattern to other forms of financing, such as mortgages. The lender carefully evaluates your application, considering your credit score, financial situation, and various factors to determine your creditworthiness. Through this assessment, they gauge your eligibility for the loan.

There are two types of loans available for purchasing a car: secured auto loans and unsecured auto loans. Most auto loans fall under the secured category, meaning that the vehicle serves as collateral for the loan. In the event of missed payments, the bank can repossess the car. On the other hand, unsecured loans are not backed by collateral, but failure to make payments can hurt your credit score and may result in your loan being handled by debt collection agencies.

While the process for obtaining either type of loan is similar, opting for an unsecured loan grants you immediate ownership of the title upon purchasing the car.

1. You apply for an auto loan

To obtain an auto loan, the first step is to submit an application. Most financial institutions, including national banks, offer auto loans. You can also explore options at local banks, credit unions, or online lenders, which often provide faster approvals.

To expedite the process and gain insight into your loan terms, you can seek preapproval. This entails a lender conducting a credit check and presenting you with a formal offer before you officially apply.

2. The lender assesses your creditworthiness

When you submit an application for an auto loan, the chosen lender will evaluate your creditworthiness to determine the loan terms they can offer. Typically, financial institutions consider factors such as your credit score, existing debts, and any late payments or potential red flags in your credit history. Additionally, some banks may review your banking history to assess the amount of available cash. It’s important to note that each lender weighs these factors differently.

3. The lender sets the amount you can borrow and your APR

The loan amount and annual percentage rate (APR) depend on factors such as your monthly income, expenses, credit score, and existing debt. These elements are carefully considered to determine the most suitable borrowing options for you.

The down payment you make will also impact your affordability. Let’s say you’re looking at a $40,000 vehicle but can only get approved for $35,000. In this scenario, a down payment of $5,000 will enable you to proceed with the purchase of the vehicle.

4. You repay the loan over a set term

The duration of your car loan has a significant impact on both your monthly payment and the total interest you’ll end up paying. A shorter loan term leads to higher monthly payments, but it also means less interest accrues over time. Typically, car loans range from 24 to 84 months.

For instance, let’s consider a $20,000 loan with a five-year term and a 6.00 percent annual percentage rate. In this scenario, the total interest paid would amount to just under $3,200. However, if we maintain the same loan amount and rate but opt for a three-year term, the total interest paid would be significantly reduced to just $1,904.

Once you have made payments on your loan for a while, you can refinance it. Refinancing can offer the opportunity to extend or shorten your loan term and potentially secure a better interest rate. Whether you choose to refinance with your current lender or explore options with a new one, take the time to shop around and find terms that align with your specific needs.

5. At the loan’s end, you own the car

The repayment process is simple. You’ll make consistent monthly payments until you’ve completely paid off your car loan. Once the loan is fully settled, you will be issued the vehicle’s title.

Direct vs. dealership financing

When it comes to financing a car, there are two primary options available. The first is direct financing, which involves obtaining a loan directly from a bank, credit union, or online lender without involving a dealership. This approach offers the convenience of dealing directly with the financial institution.

On the other hand, dealer financing entails the collaboration between a dealership and a lender to provide financing to customers. In this scenario, the dealership submits your information to various partner lenders and offers you financing based on the responses received.

While dealer financing may be convenient, it generally comes at a higher cost compared to direct financing. The interest rate for the loan often includes a markup, serving as a commission for the dealership.

To make an informed decision, it’s important to weigh the benefits and drawbacks of each financing option before proceeding.

Next steps

Gaining a comprehensive understanding of the mechanics behind auto loans and the various loan options available will empower you to make an informed decision when the time comes to purchase a car. By planning ahead, you may even uncover opportunities to save a significant amount of money.

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