How Do Car Loans Work?

A car loan is the second largest expense that you will ever have right after a mortgage. That is why it is so essential that you ensure that you get a great loan. A good car loan will have you rapidly paying down principal and saving thousands of dollars in interest payments while a bad loan will cost you a fortune in interest leaving you with negative equity. In order to save you some cash, let’s look at how do car loans work exactly?

I have learned a lot about automobile financing from my car buying experiences over the years. I have made some wise decisions and some foolish mistakes but they taught me a lot as to how car loans work. Hopefully, you can avoid making the same mistakes that I did by learning from my missteps.

My Car Buying Experiences

Toyota Solara

I have purchased three cars in my life. The first car that I purchased was a Toyota Solara.  I was fresh out of college and had bad credit. My credit score was 560 since credit card debt in college ruined my credit score. I was desperate for a car having been rejected by over 40 loan dealerships!! (It really was over 40). The only dealer who would finance me was Toyota Financial Services and the loan terms were onerous. I was stuck with a 78 month loan and 14% interest on a new car costing $22,000. It took me forever to pay that car off as I paid more in interest than the principal amount of the car. I gave away a massive amount of money by paying interest to the lender over the 6 years of the loan. After that I decided to never take on such a high amount of interest for such an extended period again.

Lexus GS300

My second car purchase was a brand new Lexus GS300. I was very excited about this purchase. My income was substantially higher and my credit was in better shape. I knew exactly what I wanted and how much I wanted my monthly payment to be. I negotiated a pretty good deal securing the car fully loaded for $52,000. I financed this vehicle through Lexus Financial Service for a rate in the single digits this time. My interest rate was around 7 percent which was pretty good for the average rate at the time. My loan term was for just over five years. However, I did make two major mistakes. 

I made too large of a down payment. I put down $26,000 on the Lexus GS300 leaving me with a balance of $26,000. If I could do it again, the maximum that I would have put down is $10,000. I was still building my investment portfolio and my overall net worth was not that high, so that $26,000 hit was substantial to me at the time. I did however pay the car off early shaving a year off my payments but I wish I had invested the majority of the down payment cash.  My other mistake was buying the car brand new. I could have saved $18,000 buying the exact same make, model, and color buying a used version of the car with only 15,000 more miles.

Porsche Panamera

This purchase was love at first sight. I loved the Panamera the moment I saw it. I passed one driving on the highway and knew that would be my next automobile purchase. It was sleek, sporty, and luxurious. I contacted a reputable dealer who was able to locate any car anywhere and told him exactly what I was looking for. This time however I wanted to get the car used to save money. The car was under two years old and barely had 14,000 miles on it. He quickly located the car and I purchased it for a fantastic price. I was able to get it fully loaded with all wheel drive, and every option. The price was well under the $109,000 price the dealership quoted me. 

This time however, I made up my mind that I was not going to tie my cash up in a hefty down payment and that I would pay this car off quickly. I only put $6,000 on the Panamera and financed the rest. Then I doubled up on my monthly payment and paid the car off in approximately 30 months. It was paid off so early that I received a GAP refund and a refund from the lender for overpaying my account. Although it was the most expensive purchase, it was my wisest financial decision. I paid a minimum level of interest, maintained my free cash in the stock market, and secured the car that I wanted.

I have gained some valuable insights from my auto buying experiences. I now understand exactly how car loans work. So, how do car loans work?

How Do Car Loans Work

Car Loan Basics

Loan Term

The term of the loan is important to watch. The average length of a car loan in the United States is 65 months. Car loans have terms that run from as short as 12 months to in an insane 97 months! A ninety-seven month car loan is a horrible deal, as you will find yourself paying interest on a depreciating asset for over 8 years. Your payment could extend well beyond the useful life of the car. Also, depending on the interest rate earned, you could be paying two to three times the value of your car. 

A 5 year auto loan is the maximum that you should ever sign up for. Longer car loans will have you making car payments and repair payments simultaneously since the extended warranty will have likely lapsed. You will be sick of making car payments into year 5 and beyond. The payments will seem unending. If you cannot pay the car loan off in sixty payments or less then the car is unaffordable for you. Five years should be your limit for paying odd a depreciating asset.

Lesson #1: Select a loan term under 60 months. 

Interest Rates

The interest rate that you pay depends primarily on factors like the loan amount, loan term, and your credit score. Good credit scores get rates in the low single digits. A good credit score can easily get a 3, 4, 5 percent annual percentage rate on an automobile. Great credit can receive a 0 percent annual percentage rate. Bad credit will receive rates in the double digits such as 18 and 20% interest on a car. High interest auto loans are a horrible deal. Using the rule of 72, you can see that a 24% interest rate will have you paying double the amount of your car’s principal amount every 3 years.  

High interest rates will have you upside down where you owe more on the car than what it is worth. This is called having negative equity or being “upside down”. People who are upside down often have to roll over their remaining loan balance into a new car loan. The old car may have died but the payments did not! Incredibly high interest rates will have you stuck in an auto loan that you will never get out of.

If your credit score is bad and your quoted interest rate is high, then you need to make a larger down payment. Increasing your down payment will lower the loan length, which subsequently lowers interest rates. This decreases your risk profile to the lender.

Lesson #2: Never take an auto loan rate above 10 percent on new or used cars.

Loan Financing

It is important to know whether you are with a prime lender or subprime lender. Subprime lenders charge higher interest fees, greater fees, and larger down payments. Subprime lenders do not trust the borrowers so they often require weekly or biweekly payments. This is very stressful for the borrower and makes it more likely to miss a payment. As soon as a payment is missed, they will repossess the car. Subprime lenders often use terms like “Easy Credit Financing” or “Your Job Is Your Credit”. 

Good credit borrowers however only have to make one payment a month. Stick with prime lenders who are reputable and are names that you know. Credit unions are the best choice to start with. They work with the auto loan buyer and have incredibly low rates. A credit union will prequalify you before you go shopping for a car so you have all of your financing in place. Credit unions are cooperatives and work with you. If you cannot get credit union financing, then go to a bank. Banks have the next lowest rates but require excellent credit to qualify for them. A bank loan is not an option for average or below average credit borrowers.

If you are unable to obtain credit from a credit union or bank, then opt for dealer financing. Ford, Toyota, Honda, Nissan, Lexus, Mercedes, Acura, Hyundai, Volvo, and Chrysler are examples of dealers who provide financing on car purchases. Dealer financing is often higher than bank or credit union financing unless you receive dealer promotional or special financing. Stick with these traditional lenders before borrowing from subprime companies that may have dubious practices. 

Lesson #3: Stay away from subprime lenders.

Monthly Payments

Your monthly payment should not be a strain on your income. If you make $2,000 a month and your car payment is $500, that’s too large a percentage of your income.  Too many people have car payments that are eating up their wealth. If you want to become a millionaire then you need to have a car payment that is easily manageable. Your monthly payment should never exceed a maximum of 10% of your gross monthly income. If it is more than that then you should look to refinance to a lower rate and a lower payment.

Refinancing a loan is an option for borrowers who have made every payment on time for a minimum of 9 months. Your local credit union is a great resource for refinancing a bad car loan that you have entered into.

Lesson #4: Keep your car payment to under 10 percent of your gross income.

Charges and Penalties

Check the loan contract for origination fees, annual charges, prepayment penalties and penalty for missing out on a payment. Find out if you will be charged for paying your loan off early. This is useful to know in case you pay your car off early or choose to refinance the loan. Decline any loans that penalize you for being financially responsible and eradicating your debt early.

Lesson #5: Make sure there are no prepayment penalties for refinancing or paying your loan off early.

Purchase Price

Car dealers love to negotiate the monthly payment and not the purchase price of the car. They will ask you questions like what do you want to pay a month? They will give you the monthly payment that you want and stretch out the loan term costing you thousands of dollars in interest. Before you sit down in the cubicle to discuss monthly payment amounts; negotiate the total amount of the loan. By obtaining your financing in advance, you can negotiate a better deal on the purchase price. Use sites like Kelley Blue Book, True Car, and Edmunds to determine the true value of the car you are buying. Credit unions and Costco can help you get lower prices on your car. Shop around online and visit competing dealerships to make sure you are not overpaying for your automotive purchase.

Lesson #6: Negotiate the total loan amount and not the monthly payment.

I hope you learned a lot reading about how car loans work. Following these simple tips will make your next car purchase much more financially friendly and leave you smiling long after you have driven off the lot.

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