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Buying a car? Here are the key terms to know about auto loans

Buying a car can leave you feeling like auto dealers are speaking a whole new language when they talk about things like a down payment, depreciation, direct lending or dealer financing. Follow this map to understand these terms and learn how financing a car can impact your budget.

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Budget

Before you buy a vehicle, review your monthly budget so that you know what you can responsibly afford. Also, consider whether you plan to trade in an existing automobile. Knowing this information will help you determine your down payment—the more you pay upfront, the less you pay each month for your auto loan.

Pre-approved financing

You can get pre-approved for an auto loan by a bank, credit union or online lender before you even begin car shopping. Knowing your approved interest rate and how much you can borrow ahead of time helps you budget and puts you in the driver’s seat when you are at the dealer.

Lenders

Most car buyers need some kind of financing to purchase their vehicle. Shopping around between different lenders can help you find the best rate.

Direct lending

  • Banks, credit unions or online lenders
  • You apply directly to the lender
  • Getting approved in advance makes it easier to shop around between dealers

Indirect lending

  • The dealer handles the relationship with the lender
  • Speeds up financing process
  • You have less control over your financing options

Down payment

A down payment is a lump sum paid up-front that often reduces the size of your monthly payments. For the lender, it reduces risk and offsets some of a new car’s initial value depreciation. A trade-in can also count as a down payment in certain instances.

For a $30,000 car with a 5 percent interest rate over a 60-month loan:

$0 down payment
Estimated monthly payment: $566

$5,000 down payment
Estimated monthly payment: $472

Terms

The term is how long you have to pay back your loan. A longer term means smaller monthly payments, but also more interest paid in total over the life of the loan. It’s important to calculate how much more interest you will owe by stretching payments over time. Check out the example below.

For a $30,000 car with a $5,000 down payment and 5 percent interest rate.

48-month term
Estimated total interest paid: $2,793.44

60-month term
Estimated total interest paid: $3,505.40

72-month term
Estimated total interest paid: $4,228.16

How long most auto loans last

The majority of people choose a loan they can pay within five to six years.

16%: 49–60 month terms.
40%: 61–72 month terms.
35%: 73-84 month terms.
9%: Other

Source: Experian, 2020

Try this auto loan calculator to get a better picture of how car price, trade-in-value and other factors can affect your monthly payment.

Interest rates

The annual percentage rate, or APR of a loan, is the interest rate plus any other fees the lender charges. It’s important to shop around in order to find the lowest interest rate. Often, you can negotiate the APR with the dealership, too. In general, the shorter your loan term and the higher your credit score, the lower your interest rate.

Depreciation

A new car’s value drops when you drive it off the lot. To avoid going “upside down” on your loan—owing more than the car is worth—try to make the biggest down payment you can manage. After 3 years, new cars are worth about 42 percent less than purchase price.

Source: Edmunds, 2020

Quick tip

Dealers may also offer you back-end products like extended warranties, tire packages or roadside assistance. Remember that if you decide to add products like these to your car purchase, their price will be financed into your loan, increasing your total cost, monthly payment and total interest paid.

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