How Auto Loans Work: Things You Probably Didn’t Know (But Should)

how auto loans work

There are 50 times as many cars on US roads today than at this time last century. This is true despite the fact that the average cost of a car has more than doubled from an inflation-adjusted $14,480 in 1917 to $33,560 today.

Most car salesmen probably don’t deserve the stereotype they are stuck with. Still, their job is not to get you the best possible deal on a car. Their job is only to get you a deal good enough to make you buy the car.

When it comes to getting the best deal possible, you are the only one who’s going to truly stick up for what’s best for you.

Since most people can’t afford to pay for a car outright, let’s look at some of the finer points of financing. Knowing just a few tricks can save you a lot of money over time.

Do you want to pay less now or later?

Outside of the loan amount, the length of your loan is the next biggest factor in determining your monthly payments. While having a lower monthly payment may feel like you just won a fabulous prize, the truth may be more grim.

Borrowing for a longer term means lower monthly payments but a higher total amount paid back over the life of the loan.

All other things being equal, each year that you add to your loan term will drop your monthly payments by about $100. It will also increase the total amount paid over the life of the loan by approximately $500. (Those are very rough averages based on a 4% interest rate.)

Auto loans are like the stock market

Interest rates on auto loans fluctuate, just like stock prices.

Once you’ve signed a loan contract, your rate is locked in and will no longer change. Before you commit to a loan, it pays to shop around and find the best deal that’s available to you.

That best deal may not come from the dealership where you get your car. As a general rule, dealerships don’t actually finance in the sense of lending money. Instead, they act as sort of brokers or middlemen to help you find a loan.

The dealership will almost always take a sort of finder’s fee for this service. That will be rolled into the loan amount and cost you more in the long run.

Banks and credit unions may or may not be a good deal. Generally speaking, you’ll almost always find your best deal online where hundreds of banks compete side-by-side for your business.

Often that competition comes in the form of loan details such as interest rates. A lower interest rate obviously means you’ll pay less. But how much less?

A difference of just 2% on a $30,000 car means a difference of around $30 on your monthly payments. Depending on the length of your loan, it also means a $2,000 – $3,000 difference in total amount paid.

The interest on auto loans is not compound interest, like it can be with some other types of loans. (Compound interest means you pay interest on unpaid interest, which can really drive up your total cost.)

The bad news is you pay back all the interest first, before repaying the amount borrowed.

So if you were to refinance — yes, refinancing is possible — it may end up being for most of the amount you originally borrowed. In that case, you’d end up paying interest on the loan amount all over again.

Pay more to save more

There are generally no prepayment penalties with car loans. So if you find yourself with a bit of extra money, you could use it to pay down the principle on your loan early and reduce the amount of overall interest you pay.

A smart strategy is to simply round up every payment. Let’s say your payments are $376 per month. By paying an even $400 and designating the extra $24 to go toward principal, you’ll pay the loan off faster.

Other things that can save you or cost you

The interest rates for loans on new cars are typically lower than the rates on used cars. However, this is more than offset by the lower sale price of used cars. That can be an important factor to keep in mind.

A larger down payment does more than just reduce the amount you need to borrow. Many lenders will give you an extra break on interest after seeing your willingness to put up your own financial stake. After all, you’re far less likely to default if it means losing a sizable down payment that came out of your own pocket.

The company that owns your car loan may also force you to get more complete, and more expensive, insurance coverage than you might want otherwise. After all, if something happens to the car, they still want their money back.

Given how quickly new cars lose their value, and the fact that most of your early payments only go toward paying interest on the loan, you might owe a lot more than the car is worth for a while. If something happened shortly after you bought your car, the insurance company may not pay enough to pay off the loan.

In such cases, there is an extra insurance policy you can get called “gap insurance” which would pay the difference and not leave you on the hook to pay for a car you may no longer own or be able to drive. While this seems like an extra expense, such policies are cheap and if you need it you’ll be very glad you have it.

At Carfect, we’re car guys. We love cars and we want you to love yours. That’s why we’ll work to find you the best car at the best price possible. We’ll also help you know how to take care of it so it gives great service for years to come.



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