When purchasing a new vehicle, many consumers opt for an auto loan. These loans, typically ranging anywhere from 12 to 84 months, can be altered drastically by a variety of factors including the buyer’s credit score, federal interest rates, and where the loan is coming from.
The goal of this Money Chat is to help you understand the basics of what goes into an auto loan calculation, how the prices of the loans are affected by interest rates, how current car prices can affect your loan, what the collateralization of autos is, and what happens with defaulted loans, and finally, financing tips to save money for your new car.
The Basics of an Auto Loan
Before getting into the details, it’s important to first mention that auto loans do vary based on location. Like any purchase, taxes in individual states affect both interest rates and sales tax on the purchase.
The agreement on the terms is key while you are purchasing a new vehicle. You will work with the lender to determine factors like – how long will it take to pay back the loan? How much money will be paid upfront? What is your credit history and how does that affect interest rates that may be available to you?
Luckily for consumers, most major banks have loan calculators to help consumers quickly judge how much they will have to pay per month for their new vehicle.
Let’s say you are purchasing a new $20,000 car. At the dealership, you will be trading in your old car for the agreed-upon $5,000 value. Because of this, you are taking out a loan for the remaining $15,000 value of the car. With the average car loan set at 72 months, you would pay roughly $229 per month for 72 months with a 3% interest rate.
How Does Interest Affect Your Auto Loan
Interest rates will be the most cost-determining factor of any auto loan apart from the length of the loan. Interest rates are determined by many factors including the federal interest rate, your personal credit score, the type of loan, and where the money comes from, however, interest rates will most likely be tied more towards your credit score.
Credit scores are determined by a lot of factors, but as your credit score goes down, your interest rate goes up. Essentially, because of a lower credit score, banks and lenders are asking you to pay more per month as a way to offset poor credit history.
In 2020, Experian found that if your credit score was between 300-500, your average interest rate ranged from 13- to 21%. If your credit was closer to the mid 700s, it dropped all the way to just 3%.
Once your credit score is determined by your personal bank or any number of personal credit reporting agencies, you can go into the auto loan process with a better understanding of the baseline interest rates that will be charged on your auto loan.
With other factors impacting the interest rate, auto loan lengths will also impact interest rates. Longer loans typically mean less monthly costs, but they also will typically increase your interest rates. For example, a 36-month loan at 5% interest on that same $15,000 purchase would roughly be $1,184 paid over the lifetime of the loan. That same rate on a 72-month loan would be $2,393.
Defaulting On Your Loan and the Collateralization of Autos
For any loan, including a car loan, missing a payment on the loan could lead to the lender declaring your account “delinquent.” Typically, this just means that the lender will reach out and ask for the money as soon as possible – usually in a 10-15 day window with a late fee – or your loan would become “default.”
Once you miss that window, a defaulted car loan can lead to a bevy of issues. First and foremost, once a loan defaults, the lender will reach out to the major credit reporting agencies and have the incident placed upon your credit record. As we mentioned above, due to credit score ratings, a defaulted loan will severely impact your credit score and drive the number down resulting in increased interest rates in the future. According to FICO – the most common credit score used in the United States – 35% of your credit score is determined by payment history on borrowed money like loans and credit cards.
After the report is made, the most typical course of action is called the “collateralization” of the loan. When a car loan is made, the lender owns the title of that vehicle until the debt is paid in full. If the loan defaults, the lender may choose to repossess the collateral of the loan, I.E the car.
While the repossession stage comes very late in the process and is determined by some selective state laws surrounding the repossession business after a car is repossessed there is typically no legal action to reacquire the car.
How Current Car Prices Affect Your Loan
The United States is currently going through a massive boom in used car prices. This is mainly due to a reviving U.S. economy and something called the global microchip shortage.
In very simple terms, because of increased demand for consumer electronics – computers, vehicles, phones – and a drastically impacted supply market due to COVID-19 shutdowns, computer microchips, which power everything from your phone to your car’s infotainment system, are in drastically short supply.
As the U.S. and other developed nations came out of the worst of the pandemic, new vehicles were in short supply with car manufacturers even forgoing certain features like start-stop engine controls to lower microchip usage. But, as new cars were sought out with no supply to meet demand, the used car market has risen nearly 30% from this time last year.
So how does that impact your new car? Well, in simple terms, higher demand for both used and new vehicles means there is less likely to be deals given on your loan. In any typical year, you’d see many dealerships offering lowered interest rates, cash upfront, or even a big slash of pricing to get you into a new car. With no supply and an inflated demand coming out of the pandemic, it is more likely lenders will raise your interest rates rather than slash them.
Financing Tips to Save Money
Here are a few tips to save money on a lengthy car loan:
- Put more money down.
While spending a lot of money upfront may defeat the purpose of a car loan, it will save you money in the long run. If you purchase a $20,000 vehicle with no money down, you could pay thousands of dollars in interest over its lifespan. If you put down $5,000, the interest payments drop steadily.
- Don’t just use the dealership.
It is convenient to use the dealership’s lending service to finance the loan, but there are many ways to set up an auto loan or lease. Typically, your personal bank may be able to give you a better interest rate in the long run. Get multiple loan quotes from multiple sources.
Refinancing a loan is essentially just reevaluating your credit as the loan goes on. While refinancing mortgages is common, you can also refinance auto loans as federal interest rates drop, or if you improve your personal credit enough to impact your interest rate. For example, if you began your auto loan at a 20% interest rate due to poor credit at the time, work with your lender to refinance as your credit gets better. If it drops to even 7% in this example, you’d save thousands of dollars in interest over the course of a 60-month lease.
- Keep the auto loan short.
For any loan, typically the shorter the term you can afford, the better. Owing money for long periods of time can be daunting, and as we mentioned – as the length of your auto loan increases, so too does the cost of interest over time. If you can afford a shorter loan, you will see not only lowered interest payments over time, but a typically lower interest rate in general as many banks and lenders charge more interest in longer loans.
- Pay for fees with cash.
This may seem small, but when purchasing a vehicle – pay for any dealership or tax fees with cash instead of rolling them into your loan. While taxes can be steep on a new or used car, placing them in the loan will only mean paying interest on taxes.
Whether it be a new or used car, auto loans should be handled with caution. Avoiding easy mistakes like high-interest rates and rolling fees into your loan can help you navigate the car buying process with ease.
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The information contained in this article is meant to serve as general guidance for consumers and not meant to serve as comprehensive financial advice. For questions about your individual circumstance, finances, or accounts, please contact your creditor(s) and/or financial advisor directly.
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