How a Loan Works

Understanding Loans

When you purchase a vehicle with a loan, a bank or other financial institution pays for most or all of the vehicle up-front, and you agree to pay back the money over time. The amount of money you borrow from the bank is referred to as the "principal." The amount of money you contribute up-front is referred to as the "down payment" and usually varies from 10% to 20% of the purchase price of the vehicle. You can often purchase a new car without a down payment (if you qualify); used vehicles generally require a 20% or more down payment.

The payback period for a loan is typically up to five years, although some newer vehicles are being sold with longer-term loans. The financial institution will charge you "interest" for your use of their money. Interest rates vary depending on a number of factors such as your credit rating and where you live. Currently, new car loan rates are around 6.5%, with used car rates about the same. Manufacturers frequently offer lower loan rates as a purchasing incentive, but sometimes these are attached to conditions that may not work for you, or are only offered to buyers with exceptionally good credit. Make sure you ask enough questions to make yourself comfortable when investigating various loan options.

The primary features of loans are summarized below.

• You have ownership and equity in the vehicle. Your monthly payments are working to purchase that car and it's yours to sell or keep as long as you wish.
  
• Gives you control over your vehicle. You can modify the vehicle, add special features or alter it. (Note that modifications may void your warranty, so check first.)
  
• Monthly payments are generally higher than with a lease.
  
• Usually involves a down payment, either a trade-in or cash.
  
• Maintenance is up to you. Always maintain your factory warranty and service your cars, but you're not on a strict schedule with penalties as with a lease.
  
• No mileage limits.
  
• At the completion of the finance period, you own the vehicle free and clear.
  
• Because a typical manufacturer's warranty is shorter than your financing term, your maintenance costs may run higher than with a typical short-term lease.

By Staff
Photo Credit: Volvo