A man signing an auto loan document.

How Do Auto Loans Work?

About to take on a new auto loan? If you are new to the game, there are some basics that you need to know. Take a look at how an auto loan works and how your payment will be determined.

For most of us, buying a new car means taking on an auto loan. To put it simply, a lender will loan you a lump sum and you pay it back over time with interest. The payment that you will be required to make will depend on three main factors.

The amount that you borrow, the interest rate and the loan term will affect how much you pay each money and ultimately how much you pay in interest over the life of the loan. Let’s quickly take a look at these three factors and how they affect your car payment.

Your Car Payment

Want a lower car payment? These are the three factors that will decide what you pay.

Loan Amount

Obviously, the more you borrow, the more you will have to pay. If you borrow $20,000 at 5 percent interest for 4 years, your payment would be $461. If you cut that down to $18,000, your payment would drop to $415. That is a significant drop.

To get that payment down, you can either buy a cheaper vehicle, negotiate more aggressively or simply put some money down.

Interest Rate

This is the biggest factor in determining the total amount of interest you pay, and it is also the hardest to manipulate. It can be done though, to some extent.

With good credit on the same loan above you will have a payment of $461 on a $20,000 loan at 5 percent interest. Drop it to 4 percent and you save $9 a month with a payment of $452. Credit not as good? A loan at 8 percent will cost you $488 a month.

Fair or not, a person with good credit can pay significantly less for the same vehicle as someone with bad credit.

Your interest rate is set by your credit and that is something that can not be changed quickly. You might be able to negotiate a lower rate however, especially from a dealer. The dealer almost always adds a few points to your rate, so you should send back their loan offer every time and ask for a lower rate.

Loan Term

This is the biggest factor in determining your monthly payment. A payment on a 5 year loan will obviously be less than that on a 4 year loan. 12 more payments means that the money can be divided out more.

On a $20,000 loan at 5 percent, the payment would be $461 on a 4 year loan and $377 on a 5 year loan. This, of course, is at the same interest rate and in reality rates go up with longer terms.

Be careful with a longer loan term. Sure, it can make your car payment more affordable but it will result in you paying significantly more interest. In addition, with longer loan terms, you will be upside down on much of the loan and that can make it difficult to trade your vehicle in down the road.

Structuring Your Loan

To some extent, all of the factors of your loan can be manipulated by you. You should do so in an attempt to save money though, not to get a more expensive vechicle into your price range. That almost always leaves you with a vehicle that you are financing for too long and overall paying too much interest on.

Look at your budget and determine the payment that you can afford. Then take that payment and fit it into a 48 month loan. If you have $400 to spend, for example, that will allow you to finance about $17,500.

Let the payment you need, over a reasonable loan term, decide how much you spend. Do not take a vehicle that is out of your price range and try to make it fit your budget.

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