Auto Loans 101: 6 Things You Need To Know

Buying a car is a major investment for most people, second only to buying a home. And, much like the dream of homeownership, you need to do your homework to make the best decisions about your auto financing.

If your New Year’s goals for 2021 include buying a new or used car, here are six things you need to know:

Credit Score

Credit scores are a big deal. Lenders use them to decide whether or not to approve your auto loan and determine your interest rate.

You can get free copies of your credit reports from the three major credit reporting bureaus once a year by visiting www.AnnualCreditReport.com. A credit score of 700 or higher is generally considered good. If your score is not where you’d like it to be, here are four ways you can start improving your credit today.

 

Monthly Payments

Your monthly car payment is calculated based three factors: how much you borrow, your interest rate and the term of your loan (the length of time it will take to pay it off). Understanding how these work can help you make smart money-saving decisions.

Ideally, your monthly payment should not be more than 20% of your take-home pay, according to the consumer advice editor at Edmunds.com. Make sure you’re buying a car that you can truly afford by using their free auto loan calculator to plug in your loan factors and find out what your monthly payment will be.

Down Payment

The down payment is the portion of your car’s purchase price that you pay for up front and out-of-pocket. A good rule of thumb is to put down 20%.

The larger your down payment, the smaller your loan amount will be, translating to a lower monthly payment and less interest fees over the life of the loan. However, if you’re among the 63% of Americans who are living paycheck-to-paycheck, it might be tempting to make a smaller down payment or look for “zero down payment” offers. Do so with caution. You’ll end up borrowing more and risk getting upside-down on your loan (meaning you’ll owe more than the car is worth).

Interest rate

The national average for auto loan interest rates in October 2020 was 5.27% on 60 month loans. However, this rate can vary based on a number of factors.

This is where your credit score becomes important. Consider this: The difference of one percentage point of interest on a $15,000 car loan over 60 months can save hundreds of dollars in interest over the life of the loan.

Loan Term

The loan term is the amount of time the lender gives you to pay off your car. You can save money on interest fees by keeping your loan term as short as you can afford.

Longer loan terms might seem like a good way to afford more car or reduce monthly payments, but they end up costing a lot more in interest and can set you up for other financial problems, like owing more than your car is worth.

Consider this example from  NerdWallet. A person financing a $27,615 car at 2.8% for 60 months will pay a total of $2,010 in interest. The person who moves up to a $30,001 car and finances for 72 months at the average rate of 6.4% pays triple the interest, a whopping $6,207.

Biweekly payments

While most loan terms are expressed in months, rather than years, you can also pay them back biweekly (meaning twice a month). This is another way to save money.

Biweekly auto loan payments shorten the term of your loan while reducing interest charges and accelerating equity. Even better, you can time them to coincide with when you get paid. It works using simple math.

Instead of making your required auto loan payment once a month, divide it in half and pay that amount every two weeks. Because there are 52 weeks in a year, you’ll make 26 biweekly payments over the course of a year (the equivalent of 13 monthly payments). On a monthly basis, your payment amount is the same. However, an extra month’s payment a year can reduce interest and shorten the term of the loan.

Use our free biweekly auto loan calculator to find out how much you can save by making biweekly auto loan payments.

Your dream of buying a car can become a reality if you do your homework, make smart decisions about how much you can afford and how you finance it, and consider making biweekly payments.

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