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How Car Loans Work

How Car Loans Work

By taking the time to collect all the necessary information, you can secure the sum of money required to buy the car you need while making sure you have enough money in the bank each month to cover your car loan repayments.

The Basics of Car Loans

Car loans work as follows:

  1. You work out how much money you need to buy a vehicle.
  2. You approach a lender and ask to borrow a certain amount.
  3. The lender reviews your circumstances and other factors to decide whether to lend you the money or not.
  4. If they do decide to lend you the money, they tell you how much they will lend you and the interest rate they will charge.
  5. You agree to the terms, conditions, and repayment schedule of the loan.
  6. You make repayments every month which reduces the amount you have left outstanding.
  7. When the loan balance is reduced to zero, you have paid off the loan.

This process applies whether you’re a U.S resident, an international student, or an expat coming to the U.S.

Understanding Principal, Interest, and Repayment Terms for Car Loans

There are several key factors you need to understand when it comes to borrowing money and taking out an auto loan.

  • Principal— the total amount of money you are borrowing, normally that would be equal to the price you’re paying for the car.
  • Interest rate— the percentage charged by the lender as a “fee” for lending you the money. This interest rate is applied to outstanding principal balance.
  • Interest amount— the amount of interest, in dollars, charged per payment.
  • Repayment schedule— the time over which you have chosen to repay the loan, it’s typically between 3 to 5 years.
  • Repayment amount— the amount you repay on a monthly basis.
  • Total amount repaid—the total cost to you of the loan, including principal and interest.

How Interest Works on Car Loans

Most auto loans are called “fixed interest” or “simple” loans—this means that the interest rate charged on the loan doesn’t vary over the lifetime of the loan. Most car loans for prime or near prime borrowers have interest rates of between 3% and 8%, depending on your credit rating, repayment schedule, and other factors.

Interest is normally calculated and applied to your outstanding balance on a daily basis. For example, assuming you have an outstanding balance of $10,000 at an interest rate of 6%, interest would be added as follows:

Assuming the balance is $10,000, the owed interest is:

  • Day 1 – 10,000 X ( 6 / 365 ) = $1.64
  • Day 30 – 64 * 30 = $49.31

Let’s assume the monthly recurring payment is $500, then the payment would cover the accrued interest and the remaining sum would reduce the outstanding principal. In our example:

500 – 49.31 = $ 450.69  would be deducted from principal, and $49.31 would be charged to pay off the interest.

APR Vs. Rate

While the interest paid for the loan is calculated according to the rate, there might be additional fees to the loan itself, such as origination fees, transaction fees, late fees etc. Those extra payments can be translated to an effective APR. Meaning, the APR is the interest rate of loan calculated as if there were no additional costs.

Calculating Interest and Repayments on Car Loans Using Auto Loan Calculators

If this looks complicated, don’t worry. There are auto loan calculators out there that can help you quickly calculate how much interest you will pay, the repayment amounts, and more. One recommended calculator is Bankrate— you can enter how much you’re borrowing, the interest rate, and the length of the loan and it will tell you your monthly repayments as well as the total you’ll be required to repay in principal and interest.

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