What is It?
An auto loan is an extension of credit designed to fund the purchase of an automobile. The lender loans you money at the time of purchase, and you agree to repay the loan by making monthly payments for a number of years. The lender charges you interest for the loan, and retains a lien on the automobile to secure repayment. In most states, the lender will keep the car's certificate of title until you repay the loan.
Generally, you must make a down payment at the time of purchase. Typically, you make the down payment in cash or by trading in another car or both. The difference between your down payment and the total price of the car, including tax and applicable charges, is the amount of money you need to borrow (loan amount). New car loans typically have repayment terms of 36 to 72 months. Used car loans generally have a somewhat shorter repayment period.
How Much Do You Need for a Down Payment?
If you are buying a new automobile, your lender will probably require you to make a down payment that is equivalent to a percentage of the purchase price. This is typically between 5 and 20 percent. Usually the dealer will offer a trade-in allowance for your old car to offset the amount required for a down payment. If you are buying a used car, the lender will typically agree to lend you 80 to 100 percent of the car's loan value. There are a number of online resources where you can find a car's loan value, such as NADA Guides and Kelley Blue Book. Keep in mind that a car's loan value differs from its wholesale or retail value. The difference between the amount the lender is willing to lend and the price of the car, including tax and charges, is the amount that you will need to come up with for a down payment. If the difference between the loan value and the retail price of a car is excessive, then you may be paying too much for the car.
Where Do You Get an Auto Loan?
Numerous financial institutions, such as banks and credit unions, offer financing for automobiles. Interest rates and terms can vary enormously from lender to lender. Choose the lender that offers the best package for your needs.
First, you will have to complete a loan application. Many banks will preapprove your loan up to a certain amount. If you have already picked out your new car, you must give the lender a copy of the purchase agreement provided by the dealership. It should include all information about the make, model, and price of the car, including its vehicle identification number. The lender will issue a draft for the loan amount, which will likely be payable jointly to you and the car dealership.
Almost all car dealerships offer in-house financing through local lenders. The dealership generally works with several lenders and can handle the entire loan process from application to contract. The dealership acts as an agent for the lender, and when the loan transaction is complete, you make payments directly to the lender.
Many car manufacturers periodically offer financing with interest rates and credit requirements that are usually competitive.
Are There Risks Associated With Auto Loans?
If you make a small down payment, it is easy to get upside down in a car loan. This means that you owe more on the loan than what the car is worth. During the first year or two of your loan, a larger portion of your monthly payment is allocated to payment of interest and a smaller portion is allocated to reduction of principal indebtedness. All the while, your new car is declining in value steadily. If your down payment was small, you may find yourself still owing a significant amount in principal indebtedness even after your car has declined in value by as much as 50 percent.
If you plan to keep the car, this is not a problem. As you continue to make payments, the principal balance will be reduced down to, and below, the value of the car. However, if you want to get rid of the car after only a couple of years, you may owe more than what your car is worth.
Example(s): Tom has a one-year-old car. He bought it for $14,000 with a very small down payment. After a year, the car has a wholesale value of $10,500. Tom, who still owes $12,000 on the loan balance, wants to trade the car in for a new one. His dealer won't give him a sufficient trade-in allowance to pay off the old loan and cover the down payment on the new loan. Tom must come up with additional cash if he wants to trade the car.
Tip: If you are the kind of borrower who trades in his or her new car every two years, you may want to consider leasing a car.
Are There Tax Implications Associated With Auto Loans?
Interest on personal auto loans is not deductible. However, if you use your automobile in your trade or business, then interest on your auto loan may be a deductible part of your vehicle expense deduction.
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