Buying a car is a major event in a person’s life and usually requires a significant amount of money. Since many people may not have $31,400 — the average price of a new car — sitting in the bank, it may be necessary to finance. While many automakers offer special financing and deals multiple times a year, it’s wise to understand how an auto loan works before signing up for one.
Most auto loans are secured loans, which means there is collateral in the event of loan default. That collateral is the car itself. If you don’t make your payments for long enough, the bank or lending institution will repossess the car. Auto loans are slightly simpler to understand than a mortgage, and there are three major components that come into play with the interest rate for an auto loan.
Daily changing interest rates
Unlike mortgage interest rates, the Federal Reserve does not set interest rates for auto loans. Instead, banks are allowed to set their own interest rates, and competition among banks and lenders tends to keep those interest rates relatively low.
However, this also means that interest rates for auto loans change from day-to-day. Before even walking into a car showroom, it may be beneficial to check that day’s interest rates. Your credit score and profile will be the final determining factor, but it’s helpful to have an idea of what banks are offering.
Simple Interest
Like mortgages, auto loans use simple interest. That is how and why your monthly payment doesn’t change over the life of the loan unless you choose to refinance. That also makes it a little easier to do the math on what your monthly loan payment will be. However, there are many auto loan payment calculators available. Simply enter the numbers to get an estimated monthly loan payment.
Simple interest benefits borrowers more than compound interest. As long as you make your monthly payments on time and in full, you won’t end up paying more for your vehicle than you originally intended or expected.
Amortization
Like mortgages, auto loans are “amortized,” meaning the interest is paid earlier in the life of the loan. This is designed to be advantageous to lending institutions so they will make the money back on their loan early on in case a borrower defaults on their payments. However, that makes it less beneficial for borrowers, especially on a car. Cars always depreciate in value, unlike homes, which tend to appreciate.
At the end of the day, your interest rate is determined by your credit. Before shopping for a vehicle, check your credit, pay down as much debt as you possibly can, and dispute any items on your credit that may be incorrect.
Your debt-to-income ratio is a major factor in determining your interest rate. If your amount of available credit is high, but your debt is also high, you may be looking at a higher interest rate. Banks collect more money from you up-front, just in case you default on your loan, which they suspect you may be more likely to do if you have a lot of debt. Eliminate this possibility by lowering your debt-to-income ratio.
For more information on auto loans, interest rates, and credit repair, visit www.creditrepair.com.
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