Car loans: how they work and conditions to know

Car loans: how they work and conditions to know

Car loans are a form of financing that allows you to purchase a vehicle by borrowing money from a lender. The loan is then repaid over a certain period, usually two to seven years. The monthly amount is determined by the size of the loan, the interest rate and the term.

How car loans work

Approval for a car loan works much the same as other types of financing. The lender will review your application, assess your credit score and financial situation, and determine your creditworthiness based on several factors.

The lender will ask for proof that you can afford the car and that you have sufficient income. In most cases, this means having a job with a steady income and a minimum credit score that varies by lender, although there are exceptions. Even if you have a good credit score, the lender will look at other factors to determine if you are a good candidate for a car loan.

Once you are approved and the lender provides you with a car loan, you will pay monthly for 24 to 84 months on a set schedule.

Car loan amounts

The amount you can borrow for a car is based on your monthly income and expenses, your credit score, and your debt load. Your down payment also affects how much you can afford. For example, if you are looking for a $40,000 vehicle, but can only be approved for $35,000, a $5,000 down payment puts you in a position where you can still buy that vehicle.

Interest rates for car loans

The interest on your car loan depends largely on your credit score, the loan amount and term and lender. The best rates go to borrowers with very good to excellent credit – usually a score of 740 to 850.

To get the best rate, check your credit report and ask for corrections if necessary. Corrections must be requested at least 30 days before you plan to apply – this is allowed. You also need to pre-qualify with at least three lenders, rather than going straight to the dealer. That way you know for sure that you get a good deal.

Conditions for car loans

The length of your car loan affects your monthly payment and how much interest you pay in total. The shorter the term, the higher your monthly amount, but you also pay less interest because you have less time to build up. Most car loans have a term of two to seven years.

For example, take a $20,000 loan with a five-year term and a 3 percent interest rate, resulting in a total interest paid of $1,562. The same amount and rate for a three-year term would be just $938 total interest.

Installment car loan

The payout process is simple. You make regular monthly payments until you have paid off the full amount of your car loan. Once it is fully paid off, you will receive the title for the vehicle. You may also be able to refinance the loan before it is paid off if you can get a better interest rate, but this process is not guaranteed.

Conditions for car loans to know

It is important to understand the components that make up a car loan. Knowing these terms and what they mean will give you a better understanding of the product and what you are signing up for when financing your vehicle.

  • Loan term: This simply refers to how long you will repay the loan. The longer the term, the more expensive your loan will generally be due to the interest accrual. It is also known as the loan period or repayment period.
  • Interest Rate: The interest rate is the percentage you will be charged for borrowing money, but it does not include fees.
  • April: The annual percentage rate (APR) is the interest rate you will be charged for borrowing the money, including fees. It also takes into account the term of the loan.
  • Deposit: This is the cash amount that you pay in advance when you buy the car. It is recommended that you make a deposit equal to 20 percent of the total cost.
  • Funded amount: This is the amount you borrow and it is usually based on your income and ability to repay the loan. This is also known as the loan amount.
  • Monthly Payment: The monthly payment is exactly what it sounds like: the amount you pay on the loan each month. It is based on the term, amount and interest rate of the car loan.
  • Total price: Once you take into account the amount borrowed and the interest paid over the life of the loan, you get the total cost of the loan.

Direct vs Dealer Financing

There are two ways to finance a car: directly through a bank, credit union or online lender, or through a dealer. Direct financing, also known as a “bank loan,” is when you apply for financing through a bank, credit union, or online lender without going through a dealer.

Dealer financing is when a dealership partners with a lender to offer you financing. The dealer sends your details to a number of partner lenders and offers financing based on what it gets back.

While convenient, dealer financing is usually more expensive than direct financing. A surcharge is often added to the interest you pay on the loan – a commission charged by the dealer.

Next steps

Understanding how car loans work and the different types of loans can help you make an informed decision when it comes time to buy a car. And with a little planning, you may be able to save even more money.

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