Unless you and your spouse have enough cash lying around to pay for a car in full, you will likely use an auto loan to finance the purchase. A lender, such as an auto dealer or bank, provides money for you to buy an auto. You make monthly payments to repay the loan over time. The terms of an auto loan depend on various factors, including your income and credit history.
An auto loan typically has a length of three to seven years, or 36 to 84 months. A longer-term loan typically has a lower monthly payment than a shorter-term loan, but you pay more money in finance charges over the life of a longer-term loan. For example, you might have a $500 monthly payment on a 36-month loan or a $300 payment on a 60-month loan, but the 60-month loan will cost more in interest over the life of the loan.
The interest rate is the annual percentage cost a lender charges you to borrow money for an auto loan. For example, if you borrow $1,000 for one year with a 5 percent interest rate, you would pay $50 in interest. A lender typically quotes an interest rate as an annual percentage rate, or APR, which is the cost to borrow money including extra charges and fees. A borrower with good employment and credit history typically qualifies for a lower interest rate, which results in a lower payment.
An auto loan’s monthly payment is typically fixed for the life of the loan. A lender applies a portion of each payment toward interest and a portion toward reducing the loan’s principal balance. As you make each payment, the portion that is applied to principal increases, which means you pay the loan down faster toward the end than toward the beginning. For example, $300 out of a $400 payment might go toward principal at the beginning of a loan, while $375 might go toward principal at the end.
An auto loan is a type of secured loan, which means that the car you buy is collateral for the loan. If you fail to make payments on time, a lender might repossess your car and sell it to pay off the loan. Make sure you can afford your monthly payment before buying a car. Shop around with different lenders to get the best deal, and take the time to understand the terms of your auto loan before signing any paperwork.