How Do Car Loans Work?

Sometimes we don’t necessarily have enough money in the bank to purchase a car up front, but we can’t manage for long without one. That’s why getting a vehicle loan might be the next best thing!

What Is A Car Loan And How Does It Work?

A car loan is a secured loan specifically for purchasing a car or other type of vehicle."Secured" means the car itself acts as collateral for the loan. So if you fail to make your payments for the loan, the moneylender can repossess the vehicle to recover their losses. When you take out a loan to buy a car (or other type of vehicle), it is a type of debt(used to pay for something that costs more than what you can currently pay upfront).

When you apply for a vehicle loan, once approved, the lender will give you an agreed-upon amount of money and accept a legal promise of repayment from you(the borrower). You are then required to pay back the car loan in instalment amounts agreed upon in the loan contract or agreement. A car loan is provided with an agreed-upon interest rate. This is extra money that you the borrower will be paying to the lender as payment for providing or lending you the use of the money for the car. For example, if the car costs $19,000 to purchase, the borrower could eventually end up paying $22,000 by the end of the transaction(including the interest payments), this is how lenders make money.

Key Players In Your Car Loan Journey

Before we get into the nuts and bolts of car loan specifics, let's identify the main

parties involved in vehicle finance.

• Borrower: That's you! The individual or entity taking out the loan.
• Lender: The financial institution providing the loan (e.g., car finance companies, banks, credit unions, or the dealership itself).
• Dealer: The car dealership where you purchase the vehicle. They often have relationships with various lenders and can facilitate the loan process.
• Guarantor: (Optional) In some cases, especially for borrowers with limited credit history, a guarantor (another person who agrees to be responsible for the loan if you do not pay) might be required.

Components Of A Car Loan

Understanding the terms you are likely to come across when applying for a car loan will help you navigate the process better and ensure a smooth transition.

• Principal: This is the original amount of money you will borrow to purchase the car initially. It's essentially the purchase price of the vehicle minus any down payment or trade-in value.
• Interest Rate: The APR or Annual Percentage Rate is the cost of borrowing money, expressed as a percentage of the principal. Having a lower interest rate means you will pay less over the lifespan of the loan. The APR includes not only the interest but also any other fees associated with the loan, giving you a better indication of the total cost of the loan.
• Loan Term: This is the duration of time over which you agree to repay the loan, typically expressed in months (e.g. 36, 48, 60, or 72 months). A shorter loan term generally means higher monthly payments but less interest paid overall. A longer term offers lower monthly payments but results in more interest paid over time.
• Down Payment: This is the upfront lump sum you pay towards the car's purchase price. A larger down payment reduces the amount you need to borrow, lowering your monthly payments and the total interest you'll pay over the entire loan period.
• Monthly Payment: This is the fixed amount you pay each month to the lender. It comprises a portion of the principal and a portion of the interest.

How Car Loan Interest Rates Are Calculated

If you are planning on buying a car and using finance, it is important to understand how car loan interest rates are calculated. Most car loans use a simple interest method, meaning interest is calculated at the interest rate on the outstanding principal balance each month. Early in the loan term, a larger portion of your monthly payment goes towards interest, and a smaller portion towards the principal. As the principal balance decreases, more of your payment goes towards reducing the principal. The following factors need to be taken into consideration.

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• Credit History. The biggest factor in the calculation of used car loan rates is the borrower's credit history. The credit history is then transformed into a credit score that gives lenders an indication of how likely you are to pay back the loan. In other words, they need to assess your ability to repay the loan because they need to be sure they will get their money back.
• Types Of Interest Rates. The two types of interest rates commonly used in car loans are the simple interest rate and the compound interest rate. Most car loans use the simple interest rate method, which is calculated using only the amount of principal owed. As the principal balance decreases, more of your payment goes towards reducing the principal. In comparison, a compound rate uses both the amount owed and the interest rate owed. So this basically means you are paying interest on the interest.
• Loan Term. Shorter loan terms mean higher monthly payments but less total interest overall. Longer loan terms mean lower monthly payments but more total overall interest. Much like mortgage payments, this is a trade off that you should consider carefully before committing to your loan.
• Debt-To-Income Ratio. The debt-to-income ratio is how much of the borrower's gross monthly income goes towards paying other debts like housing and food. So this is basically an assessment of the amount of disposable income the borrower has left over to pay back the loan.
• New vs. Used Car. Brand new cars often qualify for lower interest rates due to their lower risk profile for lenders.
• Market Conditions. General interest rates set by the Reserve Bank of New Zealand and general economic conditions can influence car loan rates.

Top 6 Tips To Take Away For Making Smart Car Loan Choices

If you have decided on getting a car loan, there are a few things you need to keep in mind in order to get the best deal.

1. Always Shop Around. Don't just take the first offer you receive or choose to work with the dealership before comparing interest rates and terms from multiple lenders.
2. Negotiate. It is okay to negotiate the car's price before discussing financing.
3. Consider A Shorter Term. If you can manage it, a shorter loan term will save you money on interest.
4. Make A Good Down Payment. The more you pay off upfront, the less you borrow and therefore the less interest you pay.
5. Understand All The Fine Print. Make sure you are aware of any additional fees or conditions to the loan before signing it! Look out for documentation fees or prepayment penalties.
6. Don't Forget The Cost Of Insurance. You should always factor in the cost of car insurance into your ongoing budget (insurance is almost always a requirement for financed vehicles).

Understanding the core components of getting a car loan including the application process and the factors that influence your loan, doing your homework, comparing offers, and choosing a loan that aligns with your financial situation will not only get you into the driver's seat of your desired car but also put you on the road to greater financial confidence. Happy driving!

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