Buying a car is certainly a critical step in the life of most Americans, and many times it cannot be accomplished directly by paying in cash: the average price of a new car in the U.S. is roughly $38,000, according to Kelley Blue Book.
The last quarter of the 2019 report of the Federal Reserve shows that roughly one-third of Americans, that is to say, 115 million people, pay a car through loan financing. This is done through a dedicated loan that is made available from banks, credit institutions, online lenders, or also from car dealers. Before choosing the borrowing route, you may want to have knowledge of its fundamentals, so that to be prepared in front of your prospective offers, and possibly not risk leaving more money than necessary on the table.
Features of auto loans
A car (or auto) loan differs not too much from a traditional loan, having interest tailored to its size and duration, and coming with specific fees; it isn’t the only way to fund your purchase, but it is likely to be the most convenient.
It can be used either for a new or used car: you borrow the necessary amount from a lender among different choices, and as with any loan you must give it back in a set term, plus the interest and some mandatory service fees.
Car loans are secured loans, which means that if you become unable to repay what you borrowed, the car itself would act as collateral, thus the lender has the right to regain possession of the vehicle and sell it; this also implies that you won’t be walking into other bad consequences, such as garnished wages unless the lender can’t recoup what you owe because of a severe depreciation of the car.
Auto loans have the “simple interest” feature, so interest is determined just on your outstanding principal balance, as in contrast would be if it was compound (where it is calculated over principal plus existing accumulated interests); in other words,
There won’t be interest accruing over previous interest applied to a schedule of past payments, so the interest amount can’t grow further adding up to the cost of the loan. This is of course an advantage in comparison with loans that impose a compound interest, such as business loans.
So you have a flat percentage applied only to the borrowed sum. As the total balance decreases because of the monthly payments, the amount of interest will accordingly diminish.
Assume you have a loan of $25,000 with a 6% interest rate, to be paid in 60 months, so your monthly payments are $483.32, including $125 of interest for the first month. In the following month, you will have an interest amount of $123.21, the remainder goes to the principal, and so on for the next months.
This also refers to as auto loan amortization: the greater portion of your payments is made towards interest at its beginning (and the lesser toward principal); it also implies that if you will make early payments to shorten the loan term, pending interest will be charged upfront.
Interest rates on car loans change daily and vary depending on market indexes, the car of choice, if it’s a new or used car, dealers or lenders of choice; factors that give more stability to rates are your individual ones, such as your credit score, amount to borrow and loan term.
Interest on car loans are normally not deductible from taxes if you are using the vehicle just for personal driving; however, you may be able to deduct a portion of the interest if a few miles are covered for business purposes, which must be declared in the taxes form (schedule C). The percentage amount of the interest deducted will be calculated in proportion to that mileage.
Car lenders will also charge “late payment fees” if your monthly payoff isn’t made within a grace period of usually 9-10 days, which is a time window of tolerance beyond the date on which a payment is due.
Loan term, namely its duration, is balanced on the purchase value of the vehicle: a longer term will mean more comfortable monthly payments, but an increased overall cost of the loan because of interest; the definitive cost of your car will be anyway enlarged by taking an auto loan. Typical terms of a car loan are generally between 24 and 72 months, aka 2-6 years, but can go beyond these limits, depending on lenders; 36, 48 and 60-month lengths are commonest.
As with a mortgage, in a car loan you will be required down payment, a sum you put upfront: the bigger you can make it, the lesser you will pay overall because you extinguish the loan sooner, thus the amount of interest is reduced. Therefore, it is generally recommended to take the time for saving, so that you can put a meaty down payment, and pay less in interest.
APR (annual percentage rate) is not just the interest rate in itself but also comprehends some fees, such as origination fee. Different lenders will offer diverse APRs, that may include a variety of things besides interest, so it is imperative to carefully read their conditions.
On top of interest, you will have fees that are due basically for the loan related operations: they are the sales tax, origination/acquisition fee, and dealer charges, and generally can make up for an additional roughly 10% over the borrowing amount. Some fees are mandatory, while others are optional and can be negotiable or not. They can be embedded in the loan recurring payments, or paid upfront, which is likely to be required if you have a fair or less credit score, but would be best in order to avoid that interest accrue on such fees.
- Sales tax are federal levies that most of the States apply on each car purchase, and usually constitutes the bulk of the fees: it can be anywhere between 2% and 6% of the car value, but it can go up to 10%, according to national and local rules
- The origination fee is to compensate the servicer for the whole procedure of application, which consists of preparing all the paperwork, inquiring about you, and a bunch of calculations. It can be a flat dollar figure, or in most cases a percentage set to 1-2% of the loan amount
- Title and registration fees are imposed for such operations
- Destination fee is for covering the cost of the car shift from the factory (but you are likely to pay it anyway) and is several hundred dollars
- Insurance fees for policies of three kinds: first, you can be offered temporary auto insurance that will cover you for accidents for a few months, depending on the dealer. However, a regular car insurance policy, providing full coverage is mandatory in the U.S. and will be anyway required by dealers. Credit insurance is optional loan protection for borrowers who during the loan lifetime may lose their job or get disabled, covering the difference of the unpaid amount. GAP insurance (guaranteed asset protection) is an add-on that takes care of the loan if the car is destroyed or stolen, paying off the difference between the car depreciated value and the remainder of the loan.
- Extended warranty, with differing characteristics and limits based on car manufacturer.
- Advertising fees imposed to compensate for the dealer’s cost of promoting the vehicle. They are not necessarily extra fees but can make part of the car purchase price (and of car loan), depending on cases.
- Early payment fees. Some lenders may prevent you from shortening the loan term (thus reducing the interest amount) by applying such a penalty.
How does a car loan work?
Whatever the source of financing, being it lenders or dealers, modalities of an auto loan will be the same. As with any loan, you have to give back the borrowed money over a certain term, and this is made in monthly payments: each payment is made of the principal balance, which is the actual sum you took, plus an interest amount that is a percentage of the balance; fees are also paid, some of which may not be applied at all. When you have signed a contract with a car dealer, but finalized the loan with a lender, this one will transfer your payments back to the seller.
Lenders offer ranges of loan terms, and you choose 60/48/36 months or whatever duration depending on your budget availability: stretching too much the loan length for buying a not so expensive car isn’t going to be convenient because of the amount of interest,
While a very short term such as 24 months might not be feasible because of high monthly payments to be faced. Many financial experts recommend to use the “20/4/10 rule”, where 4 is the loan term in years, 20 is the ideal percentage of your down payment and 10% of your gross income is how much you can spend on the car purchase.
Auto loan vs buying a car in full
The main reason one embarks on a car loan is, of course, short-term unaffordability of the car’s whole price. However, if you have cash available, you may want to consider the benefits of giving a lump sum once and have peace of mind later: above all, you won’t have monthly recurrences nor surplus to pay over the car price (interest and fees). Moreover, you get the car title soon,
Which means the asset is yours, while during a loan it is still legally considered as shared with the lender or dealer, and can be seized in case of your default with payments; still, you may need to modify the extent of insurance coverage on the car, change some of its components, or sell it without any limitations that you will have under a loan contract.
If you want to rest assured of how much you are going to spend on your car, buying it will do the job: with a car loan, you don’t know priorly unless doing the math, and may still incur late payments fees; that is to say, you have a greater expense in the long term, which might become troublesome to carry on top of other costs for things like a mortgage, etc.
Another plus is avoiding a so-called “underwater loan”(also known as “upside-down loan”): this means you are owing a certain amount to your lender, but in the meanwhile, the car value has depreciated, so you would actually pay more than it is currently worth. This is quite common, in fact, a car tends to see its value decreasing as it is driven off the lot.
Car loans and credit score
Knowing your credit score before applying for an auto loan is generally recommended, since it will let you know which rates and limits amount to check, and you will eventually apply for those deals. A free credit check can be conducted once yearly from one of the three U.S. credit bureaus: Experian, Equifax, or Trans Union: errors and/or omissions, possible reports of fraudulent activities can undermine your ability to get the loan. When one’s credit score is “non-prime”, that is to say below 660, options are lenders who have lower credit requirements, or using a co-signer’s score, in order to qualify or access to a more affordable rate; or, you may want to take the time to improve your credit status before getting a car loan, that can be done essentially paying off outstanding debts, for instance taking care of credit cards payments: consistency is of great help to your credit rating, that will go up over time, likely in a matter of months.
Your income and credit are, up to a point, mutually dependent, but credit in itself is the one that will determine your approval success: as you can see in the below table, having an excellent score will allow the best loan conditions,
| Credit score category | Average loan APR for a new car | Average loan APR for a used car |
|---|---|---|
| Deep Subprime (300 to 500). | 14.25% | 19.81% |
| Subprime (501 to 600) | 11.51% | 16.88% |
| Non-prime (601 to 660) | 7.55% | 10.85% |
| Prime (661 to 780) | 4.75% | 6.15% |
| Super Prime (781 to 850) | 3.82% | 4.43% |
Source: Experian.com
Where to get a car loan?
Before proceeding to obtain any funding, it is common sense to come up with the affordability of your loan: you will anyway end up paying a car more with a loan, than with a direct purchase; rate choice is crucial, and you should arrive prepared at the dealership table. Using our budget calculator will help determine how much you can put into this loan.
After having shopped for car models, you are left with two main options for being financed: lenders and car dealers. Auto loan lenders can be: national banks, credit unions, private online specialized companies, peer-to-peer lenders, and car dealers; the latter usually have partnerships with lending companies, otherwise lean on banks. Comparing the several options is your best bet if you want to save and find the most tailored conditions for your need.
