How Do Car Loans Work?
A lower monthly payment on your car loan doesn’t always mean you’re saving money. Here’s
A lower monthly payment on your car loan doesn’t always mean you’re saving money. Here’s how car loans work.
Purchasing a car typically means taking out a car loan. If you’re in the market for a new vehicle, you’ve probably spent a lot of time researching car options, but do you have a good understanding of how car loans work? When you take out a car loan from a financial institution, you receive your money in a lump sum, then pay it back (plus interest) over time. How much you borrow, how much time you take to pay it back and your interest rate all affect the size of your monthly payment. Here are the 3 major factors that affect both your monthly payment and the total amount you’ll pay on your loan:
- The loan amount. It can be significantly less than the value of the car, depending on whether you have a trade-in vehicle and/or making a down payment.
- The annual percentage rate. Usually referred to as the APR, this is the effective interest rate you pay on your loan.
- The loan term. This is the amount of time you have to pay back the loan, typically 36–72 months.
How do these 3 factors affect your monthly payment?
A lower monthly payment always sounds good, but it’s important to look at the bigger financial picture: That lower payment could also mean you’re paying more for your car over the life of the loan. Let’s see how adjusting each of the 3 factors can affect your monthly payment:
- A lower loan amount. Let’s say you’re considering a $25,000 car loan, but you make a $2,000 down payment or negotiate the price of the car down by $2,000. Your loan amount becomes $23,000, which saves you $44.27 per month (assuming a 3.00% APR and a 4-year term).
- A lower APR. Consider that same $25,000 car loan and let’s assume a 4-year term. One financial institution offers a 3.00% APR and another offers a 2.00% APR. Taking the lower APR will save you $10.98 per month.
- A longer loan term. Extending a $25,000 loan from 4 years to 5 years (assuming a 3.00% APR) lowers your monthly payment by $104.14, but, you’ll end up paying $391.85 more in interest charges over the life of the loan.
How a lower monthly payment can cost you more
One of the most important things to understand about how auto loans work is the relationship between the loan term and the interest you pay. A longer loan term can dramatically lower your monthly payment, but it also means you pay more in interest.
Consider a $25,000 car loan at a 3.00% APR and a 48-month term. Over 4 years of payments, you’ll pay $1,561 in total interest on the loan. If you extend that same loan to a 60-month term (or 5 years), you’ll lower your monthly payment by $104—but you’ll increase the total interest you’ll pay from $1,561 to $1,953.
Weigh all the factors before deciding
There isn’t any one-size-fits-all way to determine the best car loan. That’s why you need to take the time to understand how auto loans work and make the right decision for your specific financial situation.
Some people will benefit most by taking a longer term to reduce monthly payments and using the difference to pay down higher-interest debt. Others will prefer to make a higher monthly payment and pay off the loan sooner.
And if you have an existing car loan, you may be able to save by refinancing. Try our refinancing calculator to find out if you can lower your monthly payment by refinancing.