Aside from mortgages, auto loans are the biggest financial obligation many people ever take on. That's why it's important to understand the basics of auto financing before purchasing your first vehicle. But the key aspects of auto loans – interest, down payments, monthly payments, and financing sources – are pretty easy to grasp.
Interest (Annual Percentage Rate)
Interest is the price you pay for the use of the lender's money. It's usually a yearly rate, also known as Annual Percentage Rate (APR). According to the Federal Trade Commission, your “credit history, current finance rates, dealers' compensation, competition, market conditions, and special offers” can all affect the interest rate, which in turn affects your monthly payment. Like many other aspects of buying a car, this may be negotiable. You can increase your chances of getting a favorable interest rate by going in with a healthy credit score.
The down payment is the initial block of money you put towards the car. For instance, if a car sells for $15,000, putting $5,000 down would leave $10,000 to be borrowed. The $5,000 leaves your hands immediately, and the remaining $10,000 is paid off through monthly payments. Larger down payments offer several advantages. They can reduce the amount of interest you pay overall; they directly reduce the amount you need to borrow; and they can reduce the length of the loan, depending on its terms. However, it's wise to strike a balance between putting a bunch of money down and keeping enough in savings to deal with life's other expenses.
What you pay each month is determined by the interest rate, how much you borrow, and the length of the loan. Like a mortgage, the interest is calculated into each monthly payment, so you'll pay the same amount every month. Lower monthly payments can ease your financial burden in the short term; however, they usually mean a longer loan length. To pay off a longer loan, you'll likely rack up higher interest charges over the term of the loan. Try to strike a balance between manageable monthly payments and a loan that isn't crushingly long. On their car loan calculator site, MSN Money recommends paying “no more than 20 percent of your take-home pay toward monthly auto payments.”
Furthermore, making extra payments throughout the life of the loan can decrease the amount of time you're in debt.
Sources of Financing
Depending on your needs, you may be able to access several different financing sources. Dealerships can be extremely convenient to use, according to DMV.org, because they're “open long hours and can usually run your paperwork through while you are in the showroom.” If you don't want to waste a bunch of time hunting for financing, going through a dealership may be the quickest way to go.
Your bank or credit union can be another source, especially if you have a strong preexisting relationship. While you may be able to get a good deal from your financial institution, beware that this method isn't as convenient as dealer financing: Applications can take days, which isn't ideal if you need to buy a car in a hurry.
DMV.org also lists home equity loans and friends and family as other sources of financing. Both are viable, but both are also risky. Home equity loans tie your car to your home, so financial distress may hit doubly hard. And borrowing from friends or family can cause strain in once healthy relationships, should either party fail to meet the agreement.