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The ABCs of car loans

illustration two people buying a car

You’ve done your research and are now ready to purchase your new (or used) vehicle. Now, how do you pay for it? Unless it is an inexpensive used vehicle, most people don’t have the cash to pay for a vehicle, so they have to take out an auto loan. If you’ve never financed a vehicle, this article can get you started.

The anatomy of a vehicle loan

The first step to taking out a vehicle loan is understanding what you are getting into. There are four basic parts to an auto loan:

  • Principal. This is the amount of money you need to borrow to pay for your vehicle. If your vehicle purchase price, including, taxes, title and other fees and add-ons is $25,000, that is the principal amount.
  • Interest. This is what the lender will charge you to borrow money from them. Interest rates are expressed in annual percentage rate (APR). The rate you pay is based on your credit score, your debt-to-income ratio, your employment status, the amount of the loan, and the loan term. A smaller interest rate will result in a lower payment.
  • Term. This is the length of time you have to pay back the loan to the lender. The term is generally expressed in terms of months. New vehicle loans can have terms up to 84 months (8 years), but generally are for 60 – 72 months (5 – 6 years). A longer term will result in a lower payment, however the total interest paid will be larger because you will be paying interest for a longer time.
  • Payment. This is how much you will pay the lender each month, and it is calculated from the three items above. You can usually choose to pay every two weeks or twice a month, in which case you can save several hundred dollars. A general rule, your payment plus insurance shouldn’t exceed 20% of your disposable income.

Where to get a vehicle loan

  • Auto dealership. Many people finance their vehicle at the dealership because it is convenient to include it in the purchase transaction. Dealerships offer manufacturer financing (for new vehicles), as well as financing through local lenders. The finance department at the auto dealership often marks up the interest rate on the local institution loans so they can make a little profit. Occasionally, the vehicle manufacturer offers an especially good deal, especially if you have excellent credit or will purchase a specific model – so it pays to know what is available at the dealership.
  • Credit union or bank. By planning ahead and using your favorite credit union like White Sands FCU, or even a bank, you can save money in a number of ways. First, you generally get a lower rate going directly to the lender instead of having the dealership act as intermediary. Second, by securing your own financing, you will be able to tell the dealer that you will pay in cash – and this takes away the dealers opportunity to sell you extras in the financing package. Finally, when you go the dealer with a set price in mind, you know for certain what your payment will be and what you can afford. The dealer is a lot less likely to sell you vehicle add-ons such as extended warranties, paint and fabric protection, entertainment systems and the like.
  • Family member. If your credit isn’t great, and you have a willing and able family member, this may be an option for you. If this is your route, you will want to take steps to preserve a good relationship with your family member by making it official. Use a promissory note and write down the key terms of the loan, such as the date it is made, the amount borrowed, interest rate, length of the loan and payment amount and frequency. Be careful though – if you get into a situation where you can’t pay the loan back, it may ruin your relationship.

The application

Now that you know how an auto loan works and where to get one, it is time to submit a loan application. The application is the form you fill out, either on paper or online, that gives all your personal and financial information. The lender will require your name, address, social security number, birth date, drivers license number, employment history, monthly income and expenses and any other loans have or had in the past. They will also want to know what you are buying and for how much.

From this information, the lender will request a credit report from one of the credit reporting agencies. They will calculate your debt-to-income ratio and study your loan repayment history if you have any. All this information gives the lender an idea of your ability and likelihood of paying back the loan. Based on their risk assessment, they will either approve or deny your loan, and if approved they will quote you an interest rate and term. If you are denied a loan, or you think the rate and terms aren’t for you, apply somewhere else.

Saving money on your car loan

Follow these tips and you can reduce your monthly payment and reduce the overall amount of money you will spend on your car.

  • Know your credit score. You don’t want to be surprised by a high interest rate and or payment amount because your credit score isn’t stellar. If you know there are problems in your credit report, you may want to take steps to repair them before applying for a loan. A higher credit score will get you a more favorable loan rate.
  • Keep the term as short as possible. Although a shorter term creates a larger payment, it also reduces the amount of interest you will pay over the course of the loan. As an example, on a $25,000 car loan financed for 5 years at 5.00% APR, you will pay a total of $3,307 in interest, and your payment will be $472. On that same loan for 4 years, you will pay $2,635 in interest, and your payment will be $576. Your payment will be higher, but you will save $672 in interest expense.
  • Make a down payment. Pay in cash as much as you can. The less you finance, the less interest you will pay. If you put down 20% on your $25000 vehicle, you will only finance $20,000. The interest paid on a $20,000 loan for 5 years at 5.00% APR is $2,645, compared to $3,307 for a $25,000 loan – a savings of $626.
  • Pay for taxes and fees with cash. Again – the less you finance, the lower your payment will be and the less interest you will pay overall.
  • Get some quotes on the interest rate. You can apply at several places to get the best quote. Take the rate and term that is most favorable to you. Don’t overlook White Sands FCU as your car loan financing source. Credit unions are known for having lower rates than many traditional banks.

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