how does getting an auto loan work
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How Does Getting an Auto Loan Work?

Buying a new or used car often requires an auto loan. If you have never applied for an auto loan before, the process can be overwhelming. You need to consider your credit score, the amount of the loan, and many other details. Here is what you should know before applying for an auto loan to buy a car.

What is an auto loan?

What is an auto loan? Auto loans are intended for the purchase of automobiles, including sedans, SUVs, and other common road vehicles. Some lenders have separate loans for recreational vehicles (RVs), motorcycles, and boats.

Lenders may also use different names for auto loans, including car loans and vehicle loans. The most common lenders include banks and credit unions. With an auto loan, the borrower agrees to repay the amount of the loan plus interest over a set period. The average term (length of the repayment plan) is five to six years.

What’s the difference between a car loan and financing?

Auto loans are obtained through lenders while car financing is typically offered through dealerships. Most auto loans are direct loans arranged through a lender. However, many car dealerships also offer financing options. The “indirect loans” obtained through dealerships are not technically loans.

When a buyer arranges financing through a dealership, the buyer and the dealer agree to an installment sales contract. As with a standard auto loan, the sales contract includes an interest rate, which is called the “buy rate.” The dealership typically sells the contract to a lender. The lender then administers the loan.

What is required for an auto loan?

To apply for an auto loan, you may need to visit a financial institution or complete an online application.

Auto loans are often obtained through banks and credit unions. Many people apply for loans through their current financial institutions. However, you also have the freedom to shop around for the best interest rates.

According to Lending Tree, you typically need to provide the following information when applying for an auto loan:

  • Proof of identity
  • Social Security number
  • Proof of income
  • Proof of residence

Lenders need to confirm your identity. Acceptable forms of ID typically include driver’s licenses, state IDs, passports, and other government-issued IDs. You may also need to provide your Social Security number.

Lenders also require proof of income to ensure that you can repay the auto loan. The application form may ask for the name and address of your employer and copies of bank statements to verify your income.

Proof of residence is necessary for verifying your identity and ensuring that the lender has your most current address. After providing these details, the lender often runs a credit check and reviews your banking history.

You may also need to provide a down payment, vehicle information, and proof of insurance. Down payments are often needed for those with bad credit, as the down payment helps reduce the amount needed for a loan and demonstrates fiscal responsibility.

Vehicle information is needed to finalize the loan agreement but is not necessary when getting pre-approved for an auto loan. Many car buyers choose to apply for a loan based on the amount that they estimate they may need for a new vehicle. After getting pre-approved, the buyer is free to shop around for vehicles within their price range. After you choose a car, the lender will need to know the purchase price, vehicle identification number (VIN), year, make, and model.

How does an auto loan work?

After applying for an auto loan, the lender assesses your creditworthiness to determine the risk of you failing to repay your loan. If the risk is too great the lender is likely to deny the application. For moderate-risk applicants, the lender may approve the loan with a higher annual percentage rate (APR). Low-risk applicants are more likely to receive lower interest rates.

According to consumer credit agency TransUnion, Americans currently owe over $1.2 trillion in outstanding auto loans. About 3% of those loans are more than 30 days past due each month. Charging a higher interest rate helps protect lenders if you stop making repayments.

Lenders create a payment plan that typically includes monthly loan payments. The monthly payments are based on the amount of the loan, the length of the contract, the APR, and fees charged by the lender to service the loan. Choosing a longer repayment plan reduces the amount of the monthly payments but may also increase the APR charged by the lender.

If the loan is approved, the bank may provide a check that you write out to the dealership. After processing the check and establishing your auto loan account, you can begin making your monthly payments.

If you decide to stick with the minimum monthly payments, you will pay off the loan following the schedule agreed to in the contract. For example, if you obtain a 36-month loan, you gradually pay back the loan across 36 months.

How does interest on a car loan work?

When repaying an auto loan, you pay back the amount that you borrowed along with interest and fees. The combination of interest and fees for servicing your account is referred to as the annual percentage rate (APR). The APR is listed as a yearly percentage.

Lenders typically use one of two methods to calculate the cost of interest and fees. They may use simple interest or precomputed interest.

With simple interest, lenders simply calculate the amount of interest to charge based on the balance of the loan on the day that your payment is due using an amortization schedule. Most home mortgages are also amortized. The amortization schedule results in more of the monthly payments going toward interest at the start of the loan. As the principal balance gradually decreases, the amount of interest that you pay each month decreases. More of your payments also go toward the principal.

With precomputed interest, lenders calculate the interest upfront based on the total amount that you are borrowing. The interest is added to the principal. The total is then divided by the number of months in your repayment plan. When paying extra on your monthly payments, the extra money is applied to the payment for the following month. It contributes to both principal and interest.

If you pay extra on a simple interest auto loan, the extra money is applied directly to the principal balance. Paying down more of the balance ahead of schedule reduces the total interest that you pay on the loan.

What is a good apr on a car loan?

According to Car and Driver, 4.96% is the average APR for an auto loan for someone with excellent credit. Many websites use the average APR for those with excellent credit as an example of the typical APR that you may pay. However, most people do not have excellent credit.

Over half of Americans have bad to good credit. Credit scores are typically categorized as follows:

  • Bad credit: 300 to 629
  • Fair credit: 630 to 689
  • Good credit: 690 to 719
  • Excellent credit: 720 to 850

Some lenders will not approve loans for those with credit scores in the “bad” range while others simply charge a higher APR. The average APR for those with bad credit is 18.21%. If you have fair to good credit, the APR that you receive may land somewhere between 5% and 16%.

A “good APR” is an interest rate that results in monthly payments that you can afford to keep up with. Determine how much you can afford to repay each month and estimate how much you need to borrow. You can then use a car loan calculator to estimate the monthly payments for different APRs.

A 1% difference could significantly alter the total interest paid on the loan. For example, a $15,000 36-month loan with a 4.5% APR results in monthly payments of about $446. Increasing the APR to 5.5% increases the monthly payments to $452 and adds close to $300 in extra interest over the life of the loan.

How do you get the best deal on an auto loan?

Getting the best deal on an auto loan depends on your credit history, the amount of the loan, and how long you plan on taking to pay it back. If your main concern is lowering the monthly payments, choose a longer repayment period.

If you want the best interest rate to reduce the total amount you pay over the life of your loan, consider using the following tips:

  • Shop around and compare APRs for auto loans
  • Work on improving your credit score before applying
  • Save up more of a down payment to limit the size of the loan
  • Avoid overpaying on your new vehicle

Lenders compete to receive new loan applications by offering competitive APRs for their loan products, including auto loans. Compare APRs instead of simply applying at your current bank.

You may also want to take care of any negative credit incidents on your credit report. Request your free annual credit report to determine which issues are hurting your score the most. Improving your credit score may result in a lower APR.

You can also reduce the cost of the loan by saving more for the down payment on your vehicle. If you need to borrow less, you may receive more favorable terms. Overpaying on your new vehicle is one of the biggest mistakes you can make. Overpaying increases the size of the loan, which may also increase the APR and total cost of the loan. Looking at vehicles that are just one or two years older can decrease the purchase price.

Along with avoiding paying too much for your vehicle, Common Cents Mike, a leading YouTuber in the finance category, provides a few more recommendations. Watch the following video to learn how to avoid common mistakes when getting a car loan:

Do banks charge higher aprs for new cars?

Banks typically charge more interest when an auto loan is for a used car instead of a new car. Used cars are considered less reliable and more likely to require repairs. If the borrower defaults on the loan and the lender sells the vehicle, they may not recoup as much of the loan.

New cars are considered less of a risk, which often results in lower APRs. Banks also earn more when approving loans for new cars as new cars tend to cost more. This allows them to charge a lower APR. For example, the total interest paid for an auto loan for $20,000 with 6% APR and an auto loan for $25,000 with 4.85% APR is close to the same amount.

What happens if you default on an auto loan?

When you obtain an auto loan, the bank typically holds a lien on the vehicle. If you fail to repay your loan, the bank often has the right to repossess the vehicle and sell it to recoup its losses. Most lenders prefer to work with you to help you get back on track with your payments instead of repossessing your vehicle. Lenders typically do not start the repossession process until you are at least 90 days late on your payments.

Lenders often provide the opportunity to negotiate a new payment plan before repossessing a vehicle. For example, the past due amount may be divided into monthly installments and added to your normal monthly payments until you get caught up.

If you do not arrange a new payment plan or continue to avoid making payments, the lender may finally repossess and sell the vehicle. You are obligated to pay the balance if the sale of the vehicle does not cover the remaining amount of the loan. Along with losing your vehicle, your credit score will also suffer. The negative mark on your credit report may reduce your score by up to 100 points.

Final thoughts

Is it a good idea to get an auto loan? Obtaining an auto loan may allow you to purchase a newer vehicle with less risk of needing immediate repairs. However, the amount that you need to repay each month depends on the interest rate. Compare the APR for auto loans from multiple lenders and improve your credit to ensure that you receive the best terms.

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