How Auto Loans Work

A lower monthly payment on your car loan does not necessarily mean that you’re saving money. This is how car loans work:

Buying a car typically means taking a car loan. You’ve probably spent a lot of time researching options to find your ideal car, but do you know how car loans usually work? When you decide to take a car loan from a financial institution, you receive cash in a lump sum, and then you pay it back (along with interest) over time. Your interest rate, the amount borrowed, and the time taken to pay the amount back affect your monthly payment. These 3 major factors affect both the total amount and the monthly payment on your loan:

• The loan amount: Depending on whether you are making a down payment and/or have a trade-in vehicle, this amount can be considerably less than the value of the car.
• The annual percentage rate: Also known as the APR, this is the effective rate of interest you are required to pay on your loan. 
• The loan term: This refers to the amount of time you have to pay back the loan (ideally 36-72 months).

How Do the Above-Mentioned Factors Affect Your Monthly Payment?

Although a lower monthly payment sounds good, it is always crucial to look at the bigger (financial) picture. The lower monthly amount could also imply that you’re paying more for your car over the life of the loan. Here’s how adjusting these factors can impact your monthly payments:

• A lower loan amount: Let’s assume that you’re looking at taking a $25,000 car loan, but you negotiate the price of the car down by $2,000 or you make a $2,000 down payment. Considering a 4-year term and a 3.00% APR, your loan amount becomes $23,000, thereby saving you $44.27 every month.
• A lower APR: Consider a 4-year term and the same $25,000 car loan. One financial institution offers a 2.00% APR and another offers a 3.00% APR. Opting for the lower APR will help save you about $10.98 each month. 
• A longer loan term: By assuming a 3.00% APR and extending a $25,000 loan from 4 to 5 years, you can lower your monthly payment by about $104.14. However, you’d end up paying more in interest charges (about $391.85) over the life of your loan.

To determine the best car loan, there isn’t any one-size-fits-all way. This is why you need to spend time to understand how auto loans really work so that you can make the right decision for your specific financial situation.