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How Do Auto Loans Function?

How Do Auto Loans Function

A vehicle is typically a person’s single significant purchase. While paying cash for a vehicle is ideal, it’s not always feasible. A car loan may be an option for funding the acquisition, but its repayment may take years, so familiarity with the process is crucial.

In this post, we’ll explain how your monthly payments are determined and how they’ll alter over the life of your loan. What happens if you have difficulties making your loan payments will also be covered.

How Auto Loans Work: Terms to Know

Learn the lingo used while discussing auto loans and you’ll be well on your way to comprehending their inner workings. You should be familiar with the following borrowing terminology:

Loan amount:  You used this loan to pay for the car. Over the course of the loan’s term, you’ll make payments against the principle sum until the loan is paid in full.

Principal: The principle balance of your loan is the same as the original loan amount. The principle balance will be reduced by the amount you pay each month. After deducting all main payments made, your outstanding principal balance is the amount you owe at the end of the month.

Down payment: You’ll need to put down at least this much cash in order to buy an automobile. You may be able to buy a car with no down payment if your credit is good and your chosen auto lender doesn’t need one.

Rate of interest: The interest rate is used to compute the interest due for each billing cycle. If you owe interest, you can either use the simple interest technique or the precomputed interest method. Since the simplest approach is the most typical, that’s what we’ll do here.

Term: The time period in which you must pay back your debt in full. The amortization of a car loan is the same as the period of the loan. The term “amortization” describes the timeframe employed in determining the monthly payment of principal and interest.

Monthly payment: Principal and interest are included in this total. An amortization plan is used to determine the required monthly principle payment that will eventually pay off the loan in full by the end of the loan’s term. Each month, the outstanding principal balance is used to determine the interest due.

Fees: This is the sum of money that must be paid to the lender before any loan funds can be dispersed. Loan origination, application, processing, and title costs are all potential expenses. Lenders charge these fees to help defray the expense of extending credit. Not all lenders will charge you a fee.

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APR (annual percentage rate): Annual percentage rate (APR) means the total amount you’ll pay back on a loan each year, including interest and any other charges. This is a more accurate measure of the true cost of borrowing money than simply looking at the interest rate alone.

Cosigner: A cosigner is an additional borrower who agrees to be responsible for loan repayment in addition to the principal borrower. When a borrower lacks the credit history or other credentials to secure a loan on their own, they may turn to a cosigner. The loan is approved based on the cosigner’s credit history and the borrower’s income.

Total cost: This is the overall cost of your auto loan, including the principal borrowed, interest accrued over the life of the loan, and any origination fees or other charges levied by your lending institution.

How Your Auto Loan Payments Are Calculated?

Your monthly vehicle loan payments are determined by your loan’s interest rate, principle balance, loan term, and length. Your car loan payment is based on the sum of these factors.

There are two methods for factoring interest into your monthly bill.

Simple interest method: The simple interest technique is the most widely employed by lenders, and it simply uses the outstanding principal balance to determine the interest due each month. Prepayment of principal reduces the principal balance and, consequently, the interest due on the loan.

Precomputed interest method:  The interest rate you’ll pay under this plan is determined in advance. The easy strategy allows you to save money on interest even if you pay off your loan sooner than intended by making extra payments. This is a major disadvantage.

Although the precomputed interest approach is not often used, borrowers should be aware of it. Bad-credit loan providers and dealers who offer “buy here, pay here” financing may provide this service.

As an illustration, we’ll employ the simple interest strategy. So, you decide to finance a car and set the following parameters:

The original loan amount, term, and interest rate are all used to calculate the size of the monthly payment you’ll need to make each month until your loan is fully repaid at the end of its term. The breakdown of your monthly payment on May 1 of each year and your last loan payment is shown below:

Payment number Payment date Beginning principal balance Total monthly payment Principal portion of payment Interest portion of payment Outstanding principal balance
1 05/01/2023 $30,000.00 $579.98 $429.98 $150.00 $29,570.02
13 05/01/2024 $24,695.90 $579.98 $456.50 $123.48 $24,239.40
25 05/01/2025 $19,064.66 $579.98 $484.66 $95.32 $18,580.00
37 05/01/2026 $13,086.10 $579.98 $514.55 $65.43 $12,571.55
49 05/01/2027 $6,738.80 $579.98 $546.29 $33.69 $6,192.51
60 04/01/2028 $577.10 $579.98 $577.10 $2.89 $0.00

Your regular payment won’t change. But when you make payments over time, more of your payment will go toward the principal and less toward the interest. This occurs because the interest you pay each month is calculated in relation to the total amount of principal still owed.

Now that you know what factors into an auto loan’s monthly payment, you can see how those factors vary as you add or remove years from your loan’s duration. The total cost of your loan (excluding fees) is also displayed for each of the three possible outcomes.

Scenario 1 (Original) Scenario 2 Scenario 3
Loan amount $30,000 $30,000 $30,000
Interest rate 6.00% 6.00% 6.00%
Term 60 months 36 months 84 months
Monthly payment $579.98 $912.66 $438.26
Total cost of loan $34,799.04 $32,855.69 $36,813.56

As you can see from the table above, the overall cost of your loan is the lowest in the second scenario, despite having the highest monthly payment. Larger monthly payments mean more of your hard-earned cash is being consumed by interest charges. You save money on interest during the loan’s lifetime as a result.

This is why it’s important to go beyond the monthly payment when deciding on the best loan terms. With a longer payback period, you can reduce your monthly payment, but you’ll end up paying more for the loan overall. Pick the smallest term that still works within your budget.

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How Do You Qualify for an Auto Loan?

The ability and willingness to repay the loan is typically required for auto loan approval. Lenders use things like credit checks, employment and income verifications, and other similar measures to establish if an applicant is creditworthy.

If your credit is good to exceptional, you’ll qualify for the best rates and terms. Some auto loan providers, however, are willing to work with borrowers who have less-than-perfect credit. Debt-to-income ratios between 45% and 50% are often acceptable regardless of credit history.

A cosigner can help you get a loan if you don’t qualify for one on your own (either because of poor credit or because you’re a student without a stable income). Your cosigner’s income and credit history will also be considered by the lender when deciding whether or not to grant you a loan and at what interest rate.

Keep in mind that your cosigner assumes complete responsibility for the loan payments in the event that you cannot. Your cosigner’s credit will suffer if you don’t pay back the loan. So, to keep the friendship alive, make sure the loan is being handled properly.

How Do You Apply for an Auto Loan?

When you’re ready to apply for a car loan, fill out an application with information about yourself and your financial situation (including your monthly income and employment history). You can accomplish this in two ways:

Dealers can act as an intermediary between borrowers and lenders by accepting loan applications on behalf of a lender, automatically approving them if the borrower satisfies predetermined criteria, and forwarding the application to the lender for human approval otherwise. Dealer financing is also a possibility.

When providing indirect auto loans, some dealerships will have your best interests in mind while others will be more concerned with making a sale. In order for dealerships to participate in loan programs offered by lenders who are willing to work indirectly with them, they must often meet certain lending quality requirements.

In the future, the indirect lending program may no longer include dealers that do not match the criteria. You should research the dealership and its services thoroughly before going with indirect financing. It could be advisable to back away if it employs aggressive lending techniques.

How Do You Purchase a Car With an Auto Loan?

Your auto loan will be used to cover the cost of the vehicle in full or in part. If you are granted full financing, the entire cost of the car will be covered by the loan. You will put money toward the purchase of the car if a down payment is required.

A “dealer check” is a check issued by a bank or credit union and given to the dealership once an application has been approved. This “check” is actually paperwork outlining the dealer’s payment terms (such as supplying a copy of the title and stipulating how the money should be sent). The dealer and the lender will work out the particulars.

The dealer’s finance department will handle the entirety of the loan process, from application to sending repayment to the lending institution. You will also need to meet with the dealer’s finance division to confirm the purchase specifics (such as titling the vehicle) if you are using direct or indirect financing.

Unlike at a dealership, you’ll have to do some of the legwork when buying a car from a private party. Such actions as organizing payment with the seller and the lender and providing the lender with a copy of the vehicle’s title are examples.

How Do You Repay an Auto Loan?

Paying back a car loan is the next step after receiving one. Signing loan agreements and receiving instructions on when and how to make payments follow the completion of the car purchase. Lender payments can be sent electronically or by regular mail.

Setting up automatic payments at the time of loan application can often result in a rate reduction (often 0.25%). By providing your lender with payment information at the time of application, your payments will be made on time, every time.

Make on-time payments, regardless of the method you choose. Credit scores can take a hit if you’re charged a late payment fee (often $25 to $50). Contact your lender ahead of time if you anticipate having problems making payments or are experiencing financial hardship. One way it might help is by allowing you to pause your payments while you figure things out.

Your lender has the right to take legal action, such as repossessing and auctioning off your vehicle, if you fail to make payments on time. If the proceeds from the auction aren’t enough to pay off your auto loan and any associated costs, you may be accountable for the difference, depending on the laws in your state. Keep your payments current to avoid this.

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