How Do Auto Loans Work?

Key Takeaways

• As with most loans, more of the payment during the first few years go toward the interest due on the loan, not toward the principal loan balance.
• One way to avoid having to refinance a car loan is to shop for the best deal before you start shopping for the car.
• It’s important to understand that some of these add-ons protect your loan while others protect your vehicle or extend its warranty. 

Most people buying a new car will need to borrow money to do so. If you’re buying a new car from a dealership, you can often apply for the loan right when you pick out your car. You find a car you like and fill out loan application documents. The dealer submits the information to various finance companies and comes back with offers. Then you sign the papers and drive away with the car that day. Dealership financing may seem like the easiest approach, but it’s often not the best.

Auto loans work just like any other loan. The lender pays the dealer the amount the automobile is worth, then the borrower pays back the loan in equal monthly installments over a period of time, generally between 48-and-72 months. The shorter the time period to pay back the loan, the lower the interest rate is likely to be.

As with most loans, more of the payment during the first few years go toward the interest due on the loan, not toward the principal loan balance. Cars have become increasingly expensive over the years, so buyers are opting for longer and longer payment periods. Having more time to pay back the loan means they can make smaller payments, but they’re paying interest for much longer. The average term now is 69.5 months.

If at any time you want to reconfigure your loan details, you can refinance your auto loan if you think you’re eligible for a lower interest rate or payment amount. However as the value of your vehicle declines over time (sometimes faster than your loan balance decreases), it may not always make sense to refinance your car loan.

Shop for the loan before the car

One way to avoid having to refinance a car loan is to shop for the best deal before you start shopping for the car.

Dealers will work hard to get a loan approved for the buyer because without that they have no sale. That doesn’t necessarily mean they’re going to find the best loan for you. Dealers have a reputation for upselling, so they’ll not only try to get the loan but have you finance other things, like service contracts. Frankly, getting a car loan that way puts much higher pressure on you to accept whatever terms they get. You’re there, at the dealership, with the shiny new car and its new car smell, ready to drive off the lot.

Sales people often urge buyers to act on the impulse of the moment. So, buyers aren’t really in a position to haggle. If the dealer submits the loan and the best rate, they come back with a rate that is half a percentage point less than another loan offer, that might sound good to the buyer.

However, it’s kind of like going grocery shopping when hungry; that extra pressure doesn’t always lead to good decisions.

Consider, the average cost of a new car in 2018 was about $36,000, of which $30,000 is financed. If you’re paying interest on that amount over six years or more, finding the best interest rate is really important. So, who has the best interest rates? Generally, credit unions by a lot. In 2018 the credit unions charged an average of 3.01% interest for a 60-month new car loan. Banks charged an average of 4.80% for the same loan. That’s a savings of nearly $1,750 for a 72-month $30,000 loan. Even if the dealership is offering a special of, say, 0% interest for the first year, if the interest goes up to 4.8% afterward, you’ll still spend nearly $700 more for the car than if you had gone through a less expensive lender.

That’s one reason many lenders recommend you get pre-approved for the loan before you go shopping. In fact, for an additional $1,500, it might be worthwhile to go sign up for a credit union membership—if you don’t have one—while you’re getting pre-approved.

Moreover, when you are pre-approved for a loan, you’re in a much better bargaining position with dealers, who generally have a lot of leeway in pricing the autos they sell.

Know what kind of loan coverage you want

Dealerships are famous for upselling additional levels of coverage, warranties, and protection once your car is chosen. It’s important to understand that some of these add-ons protect your loan while others protect your vehicle or extend its warranty. If you talk to your lender ahead of time, they can help you decide which types of loan protection you do and do not need.

For example, GAP coverage is highly recommended by Credit Union of Texas if you’re buying a brand-new vehicle, have a small down payment, or are rolling negative equity from a previous vehicle into your new loan. Credit life and disability is a different type of protection that helps borrowers in situations where they are unable to work due to disability or if one of the borrowers passes away. Typically, these coverages are less expensive when purchased through the lender instead of the dealership.

Auto loans for private sales

What if you’re buying a used car from a person instead of a dealership? Can you still get an auto loan? Absolutely, but it will probably cost considerably more. A private car sale is a much riskier bet for a lender. Generally, the car is older, and there’s little chance of making sure it’s in good condition. The car is the collateral, and if the used car goes kaput, there goes the collateral. So, odds are the terms may include higher interest rates and shorter payment periods—like 48 months instead of 60.

When looking for any type of loan, it’s key to understand the lender’s focus. Dealers are focused on making as much money as possible from the sale. Lenders want to make money from lending money, so they’re interested in offering loans to people on terms that make it worth their while to take that risk. Also, credit unions like CUTX have an extra goal—we’re about protecting and helping our members. For us, it’s not about making the most money, but building the best relationships and offering loan protection products that provide value. If you want to know more about auto loans and what your options are, contact us!