How Auto Loans Work
Whether you're securing your first loan or you've been down this path before, it's essential that you fully understand how auto loans work.
If you agree to an auto loan with terms that aren't beneficial for you, it’s a decision that can come with years of regret. Instead of securing a loan that doesn't suit your budget or lifestyle, you should take the time to learn how auto loans work.
3 Key Components of an Auto Loan
Keep reading for a comprehensive understanding of the auto loan process and how the decisions you make can impact your loan.
When you get an auto loan, three things impact your loan amount the most.
Principal
The principal of your loan is the total amount of your loan minus interest and any applicable fees.
Interest
The interest is the amount of money you pay to the credit union or other financial institution for loaning you the money. The lower your credit score, the higher your interest rate will be, and vice versa.
The interest rate can range from 0% APR* to over 15% APR with the average being 4.21% APR (as of date of blog).
Term
The term is the amount of time the financial institution gives you to repay the loan. The term** can range from 24 months to 84 months or more, with an average of 60 months.
How Auto Loan Components Affect Your Monthly Payment
The principal is the most significant factor of your monthly payment. The larger your principal, the larger your monthly payment.
Auto Loan Principal Example
A 60-month $15,000 loan with 3.5% APR interest would be $273 per month
A 60-month $30,000 loan with 3.5% APR interest would be $546 per month
Your interest rate determines how much additional money is added to your loan and will increase your monthly payment accordingly.
Auto Loan Interest Rate Example
A 60-month $25,000 loan with 3.5% APR interest will be $455 per month
A 60-month $25,000 loan with 13.5% APR interest will be $575 per month
The longer the term of your loan, the lower your payment will be because it's stretching your loan out over a longer period. However, you will likely pay more in interest.
The opposite is true if your term is shorter. In this case, your payment will be higher, but you will generally pay less interest over time.
Auto Loan Term Example
A 36-month $25,000 loan with 3.5% APR interest will be $733 per month
A 72-month $25,000 loan with 3.5% APR interest will be $385 per month
Along with the principal and interest, your monthly payment might also be composed of other costs and penalties as applicable.
Types of Auto Loans
When you get an auto loan, you have options regarding the type of loan you choose. Here are some of the options.
Secured Auto Loan
A secured auto loan uses the car as collateral for the debt if you fail to make payments. In this case, the lender can repossess your vehicle to cut its losses.
This is the most popular type of auto loan.
Unsecured Auto Loan
Alternatively, with an unsecured loan, the lender won't repossess your vehicle if you fail to pay. Instead, it will try to recoup most of its money upfront by charging higher interest rates.
These are a less common option.
Simple Interest Loan
With a simple interest loan, interest is calculated based on the principal due at the time of each payment. Therefore, you will pay less interest over the loan's term because your principal will continue to decrease.
This option allows you to save money on your loan.
Precomputed Interest Loan
Unlike a simple interest loan, with a precomputed interest loan, you pay the same amount in interest each month until your auto loan is paid off.
Types of Auto Loan Lenders
Just as there are different types of auto loans, you also have several lenders to consider when getting an auto loan.
Direct Financing
You can secure direct financing through a credit union, bank, or an online finance company that provides auto loans. When you get direct funding, you can get a pre-approval for your loan and shop around to find the best deal possible.
Pros of Direct Financing
- You can get pre-approval, so you know all of your financing terms before you begin searching for a vehicle
- Lower rates overall, especially at a credit union
- When you start the process with financing, you can generally negotiate a better deal on your car
Cons of Direct Financing
- Stricter financing requirements, though credit unions are the most flexible
Indirect Financing
Indirect financing is when a dealership arranges financing between the buyer and the direct financing lender.
In this situation, you choose a vehicle at the dealership, submit a financing application through the dealership, and they work with their network of lenders to find one that will give you an auto loan.
An indirect lender network may include your current credit union, and it can be beneficial to request including it in the search for your best offer.
Pros of Indirect Financing
- The dealership sends your application to multiple lenders, and you only get one hard hit on your credit
- You might qualify for special financing offers from the lenders
Cons of Indirect Financing
- High-interest rates
- You may not be able to choose your lender
In-House Financing
In-house financing is done through buy here pay here dealerships that offer their funding, not financing through a separate dealer. This is generally provided to those who have "bad credit" and can't qualify for other financing options.
Pros of In-House Financing
- You can qualify even if your credit score is lower than average
Cons of In-House Financing
- The interest rate is generally the highest of the three options available
Factors Affecting Auto Loan Qualification
When you secure an auto loan, several factors determine your ability to qualify and the interest rate you receive.
- Credit score - the higher your score, the better the auto loan you will qualify for
- Income - you have to prove that you can afford the loan you apply for
- Employment History - along with your income, lenders like to see that you have a stable work history
- Payment History - if you recently had late/missed payments on your accounts, it will reduce your chances of qualifying for a loan or getting a reasonable rate
Choosing The Right Auto Loan
Selecting an auto loan just might be as important as choosing the right vehicle.
As you're going through the process, be sure to make a well-informed decision that will support, not hinder, your financial goals.
Here are some additional resources to help you through the auto financing process:
All rates displayed in this blog are for example purposes only and not an official RRCU rate. For current RRCU rates, please click Loan Rates.
*APR = Annual Percentage Rate. Rate and term based on credit score and year model (auto). Rate subject to change without notice. With Approved Credit.
**RRCU Terms may be extended on Auto Loans to 84 months at 60 month rate with approved credit and loan amount - Purchase or refinance from other institution only on a 2017 year model or newer - $17,000 minimum.