Financial Word of the Day: Auto Loan

Buying a car is one of the largest purchases most people make outside of buying a home. And unless you’re paying cash, there’s a good chance an auto loan will be part of the deal.

But understanding how an auto loan really works can potentially save you thousands of dollars over the life of the loan.

What Is an Auto Loan?

An auto loan is money you borrow specifically to purchase a vehicle. A bank, credit union, online lender, or dealership provides the money for the purchase, and you agree to repay it over a set period of time—with interest.

The vehicle typically serves as collateral for the loan. That means if you stop making payments, the lender has the right to repossess the vehicle.

Your monthly payment is primarily determined by four things:

• Purchase price – How much the vehicle costs.

• Down payment – How much money you pay upfront.

• Interest rate – The cost of borrowing the money.

• Loan term – How long you have to repay the loan.

A lower monthly payment doesn’t necessarily mean you’re getting a better deal.

Here’s a Simple Example of an Auto Loan

Suppose you buy a vehicle for $35,000 and put $5,000 down. You finance the remaining $30,000 with an auto loan.

If you borrow $30,000 for 60 months at 6.5% interest, your payment would be approximately $587 per month. Over five years, you would pay roughly $5,200 in interest in addition to repaying the $30,000 you borrowed.

Stretch that same loan over 72 or 84 months and your monthly payment goes down—but the total amount of interest you pay generally goes up.

That’s why focusing only on the monthly payment can be dangerous.

A salesperson might ask “What monthly payment are you trying to stay under?”

A more financially savvy question is: “What is the total purchase price, interest rate, loan term, and total amount I’ll pay over the life of the loan?”

That changes the conversation.

Learn more about loans and debt with Speak the Language of Money

How Auto Loans Can Affect Your Wealth

Cars are necessary for most of us, but they generally aren’t wealth-building assets. Most vehicles lose value over time while the borrower is simultaneously paying interest on the money used to purchase them.

That doesn’t mean you should never use an auto loan. It means you should use one wisely.

A shorter loan term, larger down payment, lower interest rate, or less expensive vehicle can leave more money available for investing, saving, paying down other debt, or building your emergency fund.

And here’s another important number to know: loan-to-value ratio.

If you owe $30,000 on a vehicle worth only $25,000, you have negative equity—you owe more than the car is worth. Long auto loans can make this problem worse because the vehicle may depreciate faster than you’re paying down the loan.

Speak the Language of Auto Loans

Instead of saying: “My car payment is $600 a month.” Learn to say: “I financed $30,000 at 6.5% for 60 months, and I understand the total cost of borrowing.”

That sounds different because you’re no longer thinking only about the payment. You’re thinking about the cost of the money.

And that’s the bigger lesson.

Don’t buy a payment. Buy a vehicle and understand exactly what the financing is costing you.

The more you understand the language of money, the better equipped you become to keep more of it, invest more of it, and ultimately create more wealth.