How do car loans work?

how do car loans work

Buying a car is one of the biggest purchases you’ll ever make, and if you’re like most Americans, you don’t have the ability to pay cash for a new or even a quality used car. That’s where a car loan can come in handy to help get you on the road by financing your vehicle.

How to get a car loan

Car loans work much like other types of loans. To take out an auto loan, you’ll complete a loan application to provide your financial institution with the necessary information including your social security number, address, employment information, income, and any debt you may have.

Once your financial institution has your background information, they’ll typically run a credit check and start with a prequalification or soft pull of your credit that won’t impact your score. If you decide to move forward with the car loan application and are preapproved, your financial institution will then do a hard inquiry on your credit which can impact your credit score. Since loan terms and approval can change over time, it’s best to do your loan comparison shopping in a short period of time.

Where to get a car loan

The three main financial institutions that can lend you money for an auto loan are the dealership, bank, or credit union. Each has their pros and cons, so it’s best to do your research and find the institution that works best for you.

Dealership

You can one-stop-shop and get a payment plan through the car dealership that sold you a car. One of the biggest pros to this route is dealers often offer low or zero-percent financing, meaning a low or no interest rate. It’s often easier to choose the car you want and handle the financing on the spot. A con to using the dealership for financing is you’ll likely need a high credit score to be approved for low or no interest financing.

Bank

Banks are a great option if you want an established lender that offers direct loans to the dealership with the car you want to buy. A big pro of using a bank for an auto loan is that banks are typically the most reliable lender. If you already have a good relationship with your bank, they might be able to work with you in case you fall behind on payments. The con of using a bank is that they typically won’t negotiate on their offer, which means you might get stuck with a higher interest rate.

Credit Union

Credit unions are non-profit organizations owned by members and governed by a board of directors. A big pro to this financial institution is that they typically offer low interest rates and a more personalized experience. Credit unions are also more likely to work with borrowers that don’t have excellent credit history and may need a little help. One con is that you have to join the credit union, and there is typically a lot of criteria you must meet to join.

Whichever institution you choose to take a loan from will become your lienholder, or, in other words, the party that owns your car loan.

What should the length of my car loan be?

Your car loan is paid back to your lienholder in monthly installments or loan payments. This monthly payment will depend on the amount of the loan, the loan term, and the interest rate you’ll have to pay over the course of the loan.

Longer-term loans (60-month or 72-months) can make your monthly payment lower, but you might end up paying more over time in interest. With longer-term loans you could end up paying more over the course of the loan than the car is worth. For this reason, shorter-term loans are typically the better option if you can manage the higher monthly payments.

How much does a car loan cost?

The cost of car loans vary, as does the interest. On average, lenders typically charge 3-5% APR interest, or annual percentage rate, based on factors such as your credit score, down payment, and loan term.

Your car loan is paid back to your lienholder through monthly installments, or loan payments. The monthly loan payment is broken down into the principal, the initial amount of the car loan, and interest on the loan, a fee your lienholder charges on top of the loan principal.

Tips to save money on your loan

Saving on an auto loan can be easy if you know what to look for. As we explained before, car loans with lower monthly payments might look more desirable but can actually cost you more in the long run with interest. And the loan offers you receive will vary depending on various factors like your credit score, income, etc.

Here are a few ways to save money on your car loan:

  • Determine a payment plan that makes sense for you. Do this before you even apply for a car loan, that way you’ll know exactly what you can afford to pay upfront and what you can swing in terms of monthly payments.
  • Don’t be afraid to shop around for your vehicle and car loan. Learn all your options before reaching a decision. You want to find an auto loan offer that fits into your set budget. While shopping around, ensure you allow yourself adequate time to read the fine print when comparing different car loans.
  • Make larger or additional payments if you can. Paying off your loan early can save you money in the long run, because you’ll avoid some of those pesky interest payments. Determine if you can afford to pay a little more each month as a part of your regular payments, or if you have some extra cash, consider putting it towards your car loan.
  • Look into refinancing your loan. If you can find a car loan with a lower interest rate than your current loan, perhaps due to your credit score improving, consider refinancing your car and switching lenders. The lower your interest rate, the less you’ll end up paying over time.

How a car loan affects your car insurance

It’s probably no surprise that financing your vehicle has some insurance implications, and failure to understand these differences can leave you vulnerable.

Driving a financed vehicle impacts your insurance coverage options, since your lienholder has a vested interest in the well-being and maintenance of your car. Having the bare minimum of liability insurance won’t cover it, so many financed cars require full coverage including:

Some other insurance coverage options worth discussing with your insurer are loan/lease insurance and GAP insurance. Loan/lease insurance provides some coverage beyond your vehicle’s actual cash value if it’s stolen or declared to be a total loss. It’s important coverage if you find yourself underwater on an auto loan or lease and you owe more than what the vehicle is worth.

GAP insurance is an add-on that covers the gap between what is owed on your car loan and depreciation, or the amount your insurance company will factor in when they pay out a claim. This reduces the likelihood of being financially underwater on your car loan if you get in an accident.

Tips to save on your insurance for a financed car

When you’re making car payments and insurance premium monthly payments, saving money is incredibly important. Here are some of the main ways to save on your insurance:

  • Pay your insurance bills upfront. Paying for your insurance premium upfront can save you an average of $85 per year. That way, your car loan payment is the only thing to worry about paying each month.
  • Bundle your insurance policies. Bundling your home or renters insurance policy with your auto insurance can save you big bucks.
  • Drive safe. Keeping a safe car in great shape and driving safely helps keep your relationship with your lienholder positive. Accidents and citations can cause your insurance premium to increase.
  • Consider telematics. If you don’t drive your car often and are a safe driver, you might want to consider usage-based insurance to save money. Telematics-based insurance uses in-car devices or apps that track the way you drive to help assign your insurance premium.
  • As we mentioned before, shop around. It’s important not to become complacent with your insurance company, so consider comparing insurance rates every six months as a way to potentially save on your premium.

At Elephant Insurance, our team of insurance experts can help you find the right plan for your financed vehicle. Get a quote for your financed vehicle, log in to review your current policy, or visit our homepage to learn more.

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