How Do Car Loans Work?

How Car Loans Work

Auto loans are a part of life for the vast majority of Americans who drive cars. Buying and borrowing smart are key to your financial prosperity.

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In a dream world, we’d all have enough cash to buy the car we really want.

In reality, 85% of new cars are financed, meaning people borrowed the money to pay for their new wheels.

Since Americans buy roughly 60 million new and used cars a year, that adds up to $1.3 trillion in debt to get a ride.

If you’re about to join that club, you could be in for a confusing journey. There are a lot of financing options. Picking the right one is as important as deciding which car to buy.

Bank loan? Credit Union? Lease? Dealer financing?

Allow us to help you navigate the financing minefield and get behind the while with a smile on your face and a little more money in your bank account.

How Does Car Financing Work?

“Financing” is basically another word for “loan.” It just sounds better, since you never hear phrases like “financing shark.”

Whichever term you prefer, the process is like buying any other big-ticket item. You seek out a bank, credit union or lending institution to loan you money to buy a car. You agree to repay that sum through monthly payments, plus interest, based on your credit rating.

Loan Amount

When it comes to buying a car, there’s often a difference with how much you want to spend versus how much car you can really afford.

You need to find that number and stick to it. As to what that number should be, you need to factor it into your other monthly debts.

Credit rating companies like to see a debt-to-income ratio of 40% or less. That means if you bring home $6,000 a month, your mortgage, credit card bills and other payments (like an auto loan), should not be more than $2,400.

So if all those add up to, say, $1,900 without a car payment, you should keep that payment under $500 a month.

If that’s not feasible, try to keep the car payment no more than 10% of your take-home pay.

Down Payment

A down payment is the amount of cash you put down to take out the loan. That actual amount is based on a number of factors.

If you have excellent credit, you might not have to make a down payment. The dealer looks at your credit payment history and says “… this guy is reliable, no down payment necessary.” Dealers also may offer zero-down-payment plans you might qualify for.

Just remember, the more you pay up front, the less your loan balance and interest payments will be.

You’ll get the best loan terms if you can make a 20% down payment. For instance, paying $6,000 up front on a $30,000 car.

Don’t sweat it if you can’t swing 20%. The average down payment on a new car is 11.7%, according to an Edmunds survey.

The average down payment on a used car is 10.9%. That’s usually enough to get you favorable loan rates since used cars already have lost much of their original value through depreciation.

Loan Term, Length of Loan

The “term” is another way of saying how long you have to pay back the loan. The options generally range from 36 to 84 months (3-to-7 years).

The average term was an all-time high of 70.6 months in March 2020. About 70% of new car loans in the first quarter of 2020 were longer than 60 months.

There’s no hard-and-fast rule for how long you should borrow money. One immutable law is that the longer that period, the more you’ll pay in interest. Your monthly payments may be lower, but you easily could pay more in the long run.

Financial experts advise keeping the loan term no longer than 60 months. The best advice is simple – the shorter the term, the better.

Interest Rate

Interest rates probably began when a caveman first loaned his neighbor furs to buy a new wheel. He got added fur back for the trouble.

Fast forward thousands of years. Interest rates are the amount of money a lender charges to use their assets. It’s typically expressed as the APR – annual percentage of the loan outstanding. According to Experian, the average interest rate on a new car in the first quarter of 2020 was 5.61%. It was 9.65% for a used car. Here’s an example of what that means in real-money terms.
If you buy a new car for $30,000, put 10% down, get a 60-month loan at 5.61%, you’d pay $517 a month for your new ride. That’s a total of $4,020 in interest over the life of the loan.

With those same terms at 4% interest, your monthly payment would be $497 and you’d pay a total of $2,712 in interest. Lower interest rate means big savings.

Where to Get a Car Loan

When it comes to choosing a lender, there are plenty to choose from. Banks and credit unions are at the top of the list.

Also check out online lenders and explore dealer financing, which is when the dealer or manufacturer loans you the money.

Whatever you do, it will pay to get pre-approved for a loan. That means you strike a conditional deal with your bank or other lending institution before you go shopping.

That will restrain you from making an impulse buy you can’t afford. And once you find a car, you can simply ask the dealer if it can offer better terms than you’re pre-approved deal. If it can, great. If not, you’d still have the money to drive away in a new car.

Banks

Banks make almost one-third of auto loans, so they’re a good place to start. As a regular customer, you might get a rate discount or qualify for some other promotion.

The bank’s loan officer can also guide you through the loan process without the pressure you might feel at a dealership.

Credit Unions

Credit unions made $375.1 billion in auto loans in 2019, according to the National Credit Union Association.

The hitch with getting a loan through credit unions is you must be a member of one. But there are more than 6,000 of them in the U.S. with more than 100 million members, so it’s not that big of a hitch to join one.

The advantage with credit unions is they are not for profit, so they don’t need to charge high interest rates to pad their bottom lines. So, by all means, check out credit unions when looking for a loan.

Online Lenders

Borrowing money to buy a car over the internet didn’t exist until, well, the internet. But it has become a major player in the lending game.

The pros are convenience, since you never have to leave your couch, and speed. You also have a variety of lenders to choose from, and it’s a lot easier to click off a website than to walk out of a loan office.

Interest rates are competitive but pay attention to fees like “origination fees” or prepayment penalties. That can add quickly to your cost.

Dealer Financing

Getting a loan from the dealer is where the buyer really needs to beware. There are good deals to be had, like 0% interest for X amount of months. But that usually means you’ll pay more on the car’s sticker price.

Dealers typically are acting as a broker for outside lenders, so they’ll mark up the interest rate or fees to make their money.

The upside of dealer financing is convenience, and dealers are more likely to work with customers with poor credit ratings. Basically, dealer financing is a good last option, but check out the other possibilities first.

How Does Financing Affect Car Insurance?

The law requires drivers to have insurance, though not all follow that law. You have no choice if you finance a car.

The lender has a financial stake in making sure the car is protected. You will not only be required to have basic car insurance, you’ll probably have to get comprehensive and collision coverages.
Once you pay off your loan, you can lower your coverages and payments if you can’t afford your car insurance. Just don’t lower them all the way to $0.00 or you’ll be breaking the law.

Some lenders may also require gap coverage. If your car is totaled in a wreck or stolen, insurance usually pays you back the actual cash value. The problem is the actual value may be less than you owe.

Gap coverage covers that difference, meaning you won’t be paying for a car you no longer have.

Alternatives to Auto Financing

Just as there is more than one way to skin a cat (though why would you want to skin a cat?), there is more than one way to get a car if you don’t want to deal with the traditional lending rigmarole.
Millions of people lease cars, pay on credit, borrow against their savings or home equity or even pay with cold, hard cash. Some people don’t bother at all and just use public transportation.

Paying Cash

Simply writing a check or peeling off a large wad of $100 bills to pay for a car is almost always the best option. No car payments! The problem, of course, is most people don’t have $30,000 to spare for a car or anything else.

The downside is you might actually be better off financially to keep that $30,000 in an interest-bearing account. That’s especially true in these days of low interest rates on car loans.

If you can get a 3% or 4% rate on a car loan, and you’re getting a reliable 5% interest return from your investment fund, you’re better off borrowing cheap money for the car.

Leasing a Car

This is a good way to drive a car you really can’t afford to buy. You basically make a down payment and then rent it for a set amount of time. About 30% of new cars driven off dealer lots are leased, according to Experian.

There are many advantages, like lower monthly payments, easy trade-ins, warranty coverage and you’ll always have a relatively new and snazzy ride.

The disadvantages are you don’t own the car, you’ll always have a monthly payment, there are mileage limits and you’ll have no cash trade-in value.

Credit Cards

Whipping out a Visa or Discover to pay for all or a portion of a car is possible, but not advisable. Some credit card companies have low-interest rate offers for large purchases like cars, but those rates have expiration dates.

If you’re not careful that low rate will expire and you’ll be whacked with double-digit interest rates. Consider a credit card your last and worst option.

Peer-to-Peer Lending

This internet marketplace was created so people could lend money to one another. As the internet has become so omnipresent, sites like Lending Tree and Prosper have boomed.

They are basically auction sites where parties on both sides agree on terms for a loan. If you’re buying a car, the pluses are it’s easier to find a lender if you have bad credit, though you’ll pay a higher interest rate. Plus, your loan isn’t secured, meaning the lender can’t repossess your vehicle if you don’t make the payments.

But it’s never advisable to welch on a loan. Your credit score will be destroyed and that could prevent you from getting any other loans for years.

Public Transportation

No matter where you get a loan, operating a car isn’t cheap. The American Automobile Association estimates it costs $9,282 a year on average to finance, buy gas, pay tolls, insure and maintain a vehicle.

That’s one reason millions of people prefer subways, trains and buses. The cost of riding them varies greatly. If you commute regularly via train in a major city, it’s not unusual to pay at least $150 a month in fees. But that’s still a lot cheaper than piling up car expenses.

HELOCs

He-whats? That’s a Home Equity Line of Credit (HELOC), where you use your house as collateral to secure a loan.

If you have a fair amount of equity, it’s relatively easy to get such a loan. But be wary of variable interest rates and know that your home is now in play. If you default on the loan, the lender could repossess the roof over your head.

What to Do When You Can’t Afford Your Car Payment

The worst thing to do if you can’t make a car payment is to do nothing. That means the lender will repossess the vehicle. Not only will you have no wheels, your credit score will look like it was hit by a Mack truck.

Call your lender and see if they will give you a loan extension or offer other refinancing options that might make the car affordable. If not, see if they will accept the car back in a voluntary repossession. If all else fails, consider selling the car to pay off as much of the loan as possible.

FAQs About Car Loans

About a million questions can pop up when buying a car. Let’s answer some of the most common ones.

Does a bank give you cash for an auto loan?

The seller may refer to you as a “cash buyer” if you finance through a bank or credit union, but you’re not showing up with actual cash.

Though it’s fun to feel like Jeff Bezos for a morning, it’s a bit risky to walk around with tens of thousands of dollars in unmarked bills. Lending institutions typically will cut you a check to give to the dealer.

Is it better to finance a car through a bank or dealership?

Financing through a bank almost always is better than through the car dealership.

The interest rates are usually lower and you’re under no pressure to close a deal. That’s not to say dealer financing isn’t worth a look. There are deals to be had with low interest rates, but crunch the numbers carefully to make sure you’re actually saving money.

Can you pay off a car loan early?

You certainly can pay off a car loan before it’s due, and it usually makes sense if you have the money to do it. But be aware that some lenders charge “prepayment fees,” which is a bureaucratic way of saying “we’re greedy and going to stick it to you for being thrifty enough to pay us back sooner than we wanted.”

Read the fine print of your contract to see if such a penalty is in there. If it is, look for a better deal.

Should I get an auto loan before going to the dealership?

It’s a great idea to get preapproved for an auto loan before you hit the showroom floor. You’ll have a set limit on what you can spend, which will keep you from getting carried away if you fall in love with a car you can’t afford.

More importantly, you won’t be at the mercy of dealer financing. If you have a loan offer in hand from the bank, you have leverage and can ask the dealer to come up with a better offer.

Does getting prequalified for a car loan hurt your credit?

Getting preapproved requires a “hard inquiry” into your credit history by the lender. That knocks a few points off your credit score.

The good news is multiple hard inquiries for car loan preapprovals are typically treated as a single inquiry by scoring models when they occur in a 14-day window.

So once you start shopping for a car and a preapproved loan, try not to take more than two weeks to close a deal.

If you’re diligent in your financing journey, you’ll look back and say the trip was worth the hassle.


Sources

Knueven, L. (2020, August 31) Here’s the average auto loan interest rate by credit score, loan term, and lender. Retrieved from: https://www.businessinsider.com/personal-finance/average-auto-loan-interest-rate

Montoya, R. (2019, July 5) How Much Should a Car Down Payment Be? Retrieved from https://www.edmunds.com/car-buying/how-much-should-a-car-down-payment-be.html

N.A. (ND) Quarterly Credit Union Data Summary, 2019 4Q: Retrieved from: https://www.ncua.gov/files/publications/analysis/quarterly-data-summary-2019-Q4.pdf

Wang, Z. (2020, April 16) Coronavirus and Auto Lending: A Market Outlook. Retrieved from: https://www.richmondfed.org/publications/research/coronavirus/economic_impact_covid-19_04-16-20

Edmonds, E. (2019, September 12) Your Driving Costs. Retrieved from: https://newsroom.aaa.com/auto/your-driving-costs/

Stolba, S. (2020, March 9) Debt Reaches New Highs in 2019, but Credit Scores Stay Strong. Retrieved from: https://www.experian.com/blogs/ask-experian/research/consumer-debt-study/