Auto Loans: How They Work
According to a recent study conducted by Experian, the average loan amount for vehicle purchases in the U.S. topped $32,000 in early 2019. While there are some fortunate enough to pay cash for their vehicle purchases, most of us rely on an auto loan in order to get behind the wheel of a new ride.
So what’s different about an auto loan? The short answer is it’s like any other loan in that a lender loans you the money to purchase your vehicle and you pay the lender back plus interest. The loan is secured by the vehicle itself as collateral until the loan is paid in full. Lenders usually do this by placing a lien on the title of the vehicle. Once the terms of the loan have been satisfied, you own your vehicle free and clear.
What are the components of an auto loan? The biggest items of an auto loan are; down payment, trade value, how many months you are financing the vehicle, and your APR. Let’s go over each of these to get an understanding of how they work within an auto loan.
Down Payment
This is the amount of cash you’re bringing to the table to buy your vehicle. While it’s tempting to buy a car with no money down, it’s not the wisest option to take in the long run. For starters, lenders will often extend better rates for their loans when you have a down payment. It basically shows the lender that you have some skin in the game as well and aren’t asking them to take on 100% of the risk by loaning you the full amount of the purchase price. While it varies by the lender what the preferred down payment should be, the general rule of thumb is between 10% and 20%.
The other big reason that having a down payment is important is to save you money in the long run. A down payment of say 20% means you’ll drive off the lot most likely with equity in your vehicle. In other words, your vehicle will be worth more than what you owe on it. This will maximize your purchasing power if you decide to trade the vehicle at some point as that equity can be applied to your next vehicle purchase. The amount of equity you’ll have will be determined by the trade value of your vehicle.
Trade Value
Almost everything has its price, including your vehicle. What your vehicle is worth is determined on several factors such as the condition of your vehicle, mileage, market conditions, etc. Let’s say your vehicle is worth $20,000 and you only owe $8,000 on the loan. That means you have $12,000 of equity in your vehicle and that amount will be applied to your new vehicle purchase. Your new $32,000 vehicle just became $20,000 and you’ll drive off with equity in your next vehicle beginning on day one.
Negative Equity
Be wary if you made a small down payment on your vehicle and decide to trade it in, as equity also works in reverse and is referred to as negative equity. Let’s say your vehicle is still worth $20,000, but you owe $24,000 on your loan. That difference of $4,000 is called negative equity because it exceeds the value of the vehicle. You may have heard the phrase ‘roll over the negative equity’, this means that $4,000 is added to your new loan if you don’t have a down payment. Remember, in order to satisfy the terms of your previous loan it must be paid in full, regardless of whether the value of your vehicle is enough to pay said loan in full. That’s why the negative equity is applied to a new loan.
Term (Number of Months Financed)
Auto loans can range from as short as 24 months to as long as 84 months. The shorter the term, the fast you’ll pay off your vehicle and the better your interest rate from the lender will be. Your payment will be higher with a shorter-term because there is less time to spread out repayment, while the opposite is true with a longer-term. Your payment will be lower because there is more time to spread out repayment. That also means it will take you longer to pay off your vehicle and the interest rate will be a little higher.
Let’s use simple math to look at this a bit further. If you had a no-interest loan of $20,000 and 24-months to repay it, your monthly payment would be $833.33, 20000/24=833.33. Now if we take that same no-interest loan of $20,000 and spread it across 60-months to repay it, the monthly payment is $333.33, 20000/60=333.33.
Keep in mind that in most scenarios, you’re paying interest on your loan and the longer you take to repay it, the more you’ll pay in interest. Most people choose either 60-months or 72-months to repay their auto loans as it fits better into their budget and often people can take advantage of special financing rates offered to get the best of both worlds, a lower monthly payment, and a lower APR.
APR (Annual Percentage Rate)
This is the interest rate that the lender sets for your auto loan. Factors that help the lender determine your APR include your credit score, loan term (months to repay), vehicle value, and mileage. Your credit score has a significant impact on your rate but is not the sole factor. Let’s talk about those other factors.
A vehicle’s value comes into play in the form of how much of a down payment you had. If the vehicle you’re purchasing is valued at $20,000 and you're requesting to borrow $22,000 because you wanted to go the no money down route and taxes, tags, and fees added to the total price, your rate is going to be higher than if you had elected to put money down.
Mileage plays a factor in used vehicles and can impact your rate as well. If you take 2 identical vehicles and parked them side-by-side, with the only difference is one has 100,000 miles and the other has 40,000 miles, the vehicle with fewer miles will get you a better interest rate. Now, of course, the vehicle with fewer miles is going to be worth more and thus have a higher purchase price. So, it may boil down to what works best for your budget.
Finding the Balance
Now that we’ve gone over the basics of how an auto loan works, you’ll have a better idea on determining how much vehicle you can afford without going over your budget. If you’ve read this far, I’m going to give you an auto loan hack to help you stay on budget and save some money at the same time.
If your budget is $400 per month and your loan payment is $300 per month for 60-months, pay $400. You will pay off your car faster and pay less in interest because you didn’t need the full repayment schedule to pay it off. Getting some overtime pay? Great! Add another $50 to your payment and pay $450.
Want to see what a monthly payment might look like on your next ride? Use my Payment Calculator tool and see what your buying power looks like for your budget.