With the average auto loan reaching $39,721 in 2021 according to Experian data, most car buyers opt to finance their vehicles rather than pay cash. Deciphering which auto loan is the best for you can seem complicated, though. Let's go over some basic auto loan terms so you can be more confident in your financial choices before you finance a car. Here are nine essential car loan terms you should know before you head to the dealership.
1. Down Payment
A down payment is cash you pay the vehicle seller or dealer toward the total price of the vehicle. The trade-in value of your current vehicle or manufacturer incentives, such as cash rebates, may also be applied toward your down payment. The bigger your down payment, the less money you need to borrow. In general, your down payment should equal at least 20% of the purchase price for a new car and 10% for a used car.
2. Interest Rate
The interest rate reflects how much you pay annually to borrow money. Installment loans such as car loans usually roll the interest into your monthly payment. Each payment you make goes partly toward interest and partly toward the balance of the loan principal. As you pay off your car loan, less of each monthly payment goes toward interest charges.
3. Annual Percentage Rate (APR)
The APR of a loan is the total cost to borrow the money, including interest, as well as any other fees, such as loan origination fees. Auto loan costs included in the APR may be called prepaid financing charges. Examining the loan's interest rate and APR will reveal how much of your loan costs are fees. In some cases, you may be able to negotiate reduced fees, which will lower your total loan cost. When shopping for loans from different lenders, it's best to compare APRs instead of interest rates.
4. Manufacturer's Suggested Retail Price (MSRP)
The MSRP is the price that the car's manufacturer recommends car dealers should charge for the vehicle. It's sometimes called the list price or sticker price. It's common for car buyers to negotiate a price that's lower than the MSRP.
5. Prepayment Penalties
Some lenders charge prepayment penalties if you pay off your loan before the end of the term. When you repay your loan early, the lender loses some of the interest you would otherwise have paid. A prepayment fee helps recoup some of that money. Like other fees, prepayment penalties must be stated in the loan contract. Sometimes they're deep in the fine print, however, so it's a good idea to ask.
A loan's principal is the amount you are borrowing to pay for the car, as well as to cover taxes and fees. Loan principal does not include interest charges. For example, if it costs $35,000 to buy a vehicle, you might put down $7,000, and finance the remaining $28,000. The principal is the $28,000 you'll pay off over time. When you make a payment, part of each payment goes toward the loan principal and part goes toward interest.
A loan's term is the amount of time you have to pay back the loan. When it comes to auto financing, the term is usually expressed in months. As car prices rise, average auto loan terms are getting longer. The average term of a new vehicle loan was 69.50 months in the first quarter of 2021, according to Experian data. Auto loans are now available with terms as long as 96 months (eight years). While longer-term loans typically mean lower monthly payments, they usually charge higher interest rates than shorter-term loans, costing you more in the long run.
8. Total Cost
The total cost is the full amount you'll pay to buy a vehicle. This figure includes your down payment, the value of any trade-in, principal, interest and fees. Using the example above, a $28,000 loan with a 60-month term and a 5% interest rate will ultimately cost the borrower $3,703 in interest, which brings the total cost of the loan to $31,703. Add in the $7,000 down payment and the total cost paid for the vehicle is $38,703.
9. Truth-in-Lending Disclosure
The Truth-in-Lending Disclosure is a document that provides a borrower with key information about a loan. The federal Truth-in-Lending Act (TILA) obligates lenders to give you this disclosure before you sign a loan contract. It's often included as part of the loan contract. TILA disclosures include:
- Loan APR: The cost of the loan, including interest and fees.
- Finance charge: The sum of interest and fees you'll pay over the loan term, expressed as a dollar amount.
- Amount financed: The dollar amount that you're borrowing.
- Total of payments: The total dollar amount of payments you'll have made when the loan is paid off (including principal, interest and fees).
TILA documents also disclose your monthly payments, the number of payments to be made during the loan term, whether there is a prepayment penalty and any fees for late payment. Carefully reading the TILA agreement can help you decide whether the loan makes sense for you.
Find the Right Auto Loan for You
Having good or exceptional credit can make it easier to qualify for an auto loan that offers favorable terms and low interest rates. Before you start car shopping, check your credit report and credit score to see where your credit stands and whether it needs improvement.
Consider getting preapproved for an auto loan from a bank, credit union or other lender before visiting the dealership. Having a credit offer in hand can make it easier to negotiate with the auto dealer. Making your car payments on time can help boost your credit score, but late payments could hurt it. Taking the time to shop for the best auto loan helps ensure you find financing that you can afford.