Takeaways
- Car notes are the second highest category of consumer debt in the U.S.
- The average term of a car note is approximately 72 months (6 years).
- Banks, credit unions, and dealers offer car loans in 12-month increments.
- Choosing an auto loan with a shorter term will increase your monthly payments.
- Budgeting for your monthly car payment is part of the affordability calculus.
Owning your dream car can be an exhilarating experience, but navigating how to pay for your new ride with a car loan can often feel overwhelming. The good news is that you are not alone because millions of Americans have been through this process before. The outstanding auto loan balance stands at $1.61 trillion in the U.S. and has continued to climb for several years [1].
Equipped with the knowledge and understanding of how the process works, you can confidently navigate the car financing process and secure the best possible loan for your needs. The right loan will free you to find the perfect car.
What is a Car Loan?
A car loan is a long-term loan issued by a bank, credit union, or dealer to help you finance the purchase of a new or used car. You can get an auto loan when you want to buy a car but do not have enough cash. Car loans are consumer debt to purchase a car or truck.
A car note has a similar structure to other consumer debt like mortgages. Your car loan represents the amount of your car’s purchase price minus your down payment. This amount represents the principal of your car loan and will need to be paid back with interest over time through monthly installments until the loan is paid.
How a Car Loan Works
Finding your dream car involves shopping for the exact car you want and then figuring out how you are going to pay for your car. Unless you are purchasing your car with cash, you will most likely need to take out a car loan to finance your purchase. Here is how the process works:
Application Process
During the application process, lenders assess various aspects of your financial history. This may include analyzing various financial measurements like your credit score, employment history, income stability, and debt-to-income ratio. These factors will potentially gauge your creditworthiness and determine the terms of your loan.
Some lenders may offer pre-approval options. A pre-approval letter is a document from a potential lender stating that they will lend you up to a dollar limit. Knowing you have the financing can boost your confidence when car shopping and allow you to negotiate better deals.
Learn More -> What is a FICO score?
Approval and Agreement
Once you are approved for a car loan, you will receive a loan agreement outlining the terms and conditions of your specific loan. The loan agreement will specify the loan amount, interest rate, annual percentage rate (APR), loan term, repayment schedule, and additional fees or charges.
Before you sign any document, you must take your time to review your loan agreement. Read through the pages carefully and ensure you understand all the terms and conditions.
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Vehicle Purchase
Finding the best car to purchase is no walk in the park. You will probably need to spend hours researching the type of car you want and its various makes, trim packages, fuel efficiency, seating capacity, and other features.
You should research the market, compare prices, and inspect the vehicle thoroughly before purchasing. Use sites like Carvana, CarMax, or CarGurus to get a sense of the asking prices of the car you are looking to purchase.
Unless you think you will drive this car until it falls apart, consider factors such as depreciation, resale value, and vehicle history reports to make an informed decision. After you decide what vehicle to want, you can get a new or used car from a traditional car dealership or private seller.
Commencement of Repayment
Part of the analysis process of buying any car is payment affordability. Before agreeing to purchase a car, you want to check your budget to see if you can comfortably afford your monthly car note payment. After you sign on the dotted line, you will be on the hook for your auto loan until the principal and interest are paid in full.
Once you start repaying your auto loan, timely payments are critical to avoid penalties and fees. You can set up automatic payments or reminders to stay on track with your repayment schedule. If you get a financial windfall like a bonus or start earning more money, consider making extra payments or paying bi-weekly to accelerate the repayment process and save on interest costs.
Completion of Loan
Paying off your auto loan is a significant financial milestone. Not only will this allow you to become debt-free, but you will own your car outright.
After your final principal and interest payment you will receive a satisfaction of the lien or release of the lien document. This document shows that the lender no longer has a legal claim on your vehicle, and you are debt-free. This is when the vehicle title officially passes to you. At this point, you officially own the car free and clear. Now, you can celebrate that achievement.
7 Common Car Loan Terms
Whether you are buying your first car or have not taken out an auto loan in a while, you should familiarize yourself with some industry terms. Understanding these auto loan terms will educate you on the car buying process and give you the confidence to know what variable to focus on. Here are seven car loan terms to know:
1. Down Payment
A down payment is the amount of cash you will put toward the purchase price of a car. You do not need an auto loan if you have enough to purchase a car. A down payment plus your auto loan will equal the purchase price. The higher your down payment, the less you need to borrow.
While a larger down payment reduces your loan amount and decreases monthly payments. Strike a balance between the size of your down payment and maintaining sufficient savings for emergencies. Personal finance experts generally advise against dipping into your emergency fund or slush fund to get the cash necessary to purchase a car. Instead, they recommend putting together a savings plan and saving for your down payment as part of your financial planning.
Smart Tip:
Aim to put down at least a 20% down payment for your car. This will help with affordability and shield your value.
2. Interest Rate
All auto loans will come with an interest rate. Interest rates vary based on the lender and your financial history, such as factors like your credit score and loan term, as well as broader economic conditions. Consider shopping around and negotiating with lenders to secure the most competitive interest rate possible.
Due to rising inflation, the Federal Reserve has increased the federal funds rate. As a result, auto loans for used and new cars have increased to approximately 6% in 2024.
3. Annual Percentage Rate
In addition to your loan’s interest rate, you should also pay attention to the annual percentage rate (APR). The APR includes fees, such as origination or processing expenses and closing costs. Understanding the APR provides a more accurate representation of the total cost of borrowing and allows for better comparison between loan offers from different lenders.
APY is a critical variable to consider when shopping for loans. You will have to balance your loan’s terms with your APY.
4. Principal
The principal amount of your car loan is the actual amount you are borrowing from the bank, credit union, or car dealership. Interest expense is calculated based on your principal. The higher your principal, the more you will have to pay interest over the life of the loan.
As you make monthly payments throughout your loan, a portion of each payment goes towards reducing the principal balance, and a portion goes toward paying interest. Monitoring the principal balance over time can help you track your progress toward loan payoff and assess the impact of additional payments or refinancing strategies.
Smart Tip:
Most lenders will let you make loan payments directly toward the principal balance. However, some lenders limit the amount you can pay each month through their apps and websites. To pay off your principal, you might have to go in person with a check. Consult your lender for more details on your specific loan.
5. Loan Term
A loan term is the length of your loan. Loan terms are issued in 12-month increments.
Here are the most popular terms:
• 12 months
• 24 months
• 36 months
• 48 months
• 60 months
• 72 months
• 84 months
Shorter loan terms result in higher monthly payments but enable you to pay off the loan faster and save on overall interest costs. Conversely, longer loan terms offer lower monthly payments but may result in higher total interest payments over the life of the loan. Consider your budget, financial goals, and plans when selecting the loan term that best fits your needs.
6. Monthly Payment
Your monthly payment consists of both principal and interest. It also consists of applicable taxes and car insurance premiums (if included in the loan). Make sure you factor in the monthly payment amount when budgeting for other expenses and ensure it aligns with your financial goals and obligations.
7. Total Cost of Car Ownership
Your monthly auto loan payment is not your only car expense. You will also need to consider car insurance, registration fees, maintenance, and fuel costs. Calculating the total cost of ownership helps you assess the affordability of your vehicle over the long run and plan for ongoing expenses beyond the initial purchase price and loan payments.
How to Compare Auto Loans
When you have multiple loan options, it can be hard to know where to start. However, comparing auto loans with the information outlined below can help you make a more informed decision.
Interest Rates and APR: While securing a low interest rate is important, it is equally crucial to consider the annual percentage rate, as it provides a more comprehensive view of the total cost of borrowing [2]. Compare multiple loan offers from different lenders to identify the option with the most favorable terms and lowest overall cost.
Loan Terms: Evaluate the trade-offs between shorter and longer loan terms, considering factors such as monthly payment amounts, total interest costs, and financial flexibility. When selecting the optimal loan term, consider your financial goals, budget constraints, and anticipated changes in income or expenses. Everyone’s financial situation is different, so choose a term that works for you.
Total Cost Evaluation: In addition to comparing interest rates and monthly payments, calculate the total amount paid over the life of the loan, including interest and fees. There is a stack difference between the total lifetime cost of a BMW versus a Honda Civic. This holistic approach ensures you choose the most cost-effective loan option that aligns with your financial objectives and constraints.
Flexibility Considerations: Examine the flexibility features offered by different lenders, such as the ability to make extra payments, skip payments in case of financial hardship, or refinance the loan to secure better terms. Choose a lender that offers the most favorable terms and flexibility to accommodate changes in your financial situation over time. Be wary of any lender that makes it difficult for you to make monthly payments or pay off your auto loan.
Down Payment Requirements: Evaluate the down payment requirements imposed by lenders and consider how they impact your upfront costs and monthly payments. If necessary, consider earning more income or stashing away some cash for your down payment. Some lenders may offer programs with low or zero down payment options for qualified borrowers, which provides greater flexibility and affordability.
Smart Summary
When it comes to purchasing a new or used car, you should try to get the best auto loan possible. Play around with Smart Money’s auto loan interest calculator to get a better idea of affordability. Tools like this can help you compare interest rates on the same term loan and give you clear insight into what auto loan works best for your finances.
(1) Federal Reserve Bank of New York. Quarterly Report on Household Debt and Credit 2023:Q4. Last Accessed March 28, 2024.
(2) Liberty Street Economics. Auto Loan Delinquencies Revs Up as Car Prices Stress Budgets. Last Accessed March 29, 2024.
