A new car can represent freedom, but for many drivers it also means a five-year loan and another monthly payment to the household budget. Auto loans are issued by lenders that work with car dealers to provide loans at competitive interest rates. Understanding how finance charges are calculated is essential to knowing what a new car will actually cost you.
Understanding APR
When you buy a car the dealer is likely to quote you an annual percentage rate, or APR. This number represents the percentage the lender will multiply by the amount you owe (the principal balance) to determine your finance charge. But lenders compute finance charges monthly, not annually. This means you need to divide the APR by 12 to determine the monthly interest rate. For example, an APR of six percent means a .5 percent (.005) monthly interest rate.
Monthly Charges
If you buy a $20,000 car with a $5,000 down payment, you'll owe $15,000. At a six percent APR, your first month's finance charge will be $75 ($15,000 x .005). This means $75 will go towards interest and the rest toward reducing your principal balance. Your next payment will have a smaller principal balance but still the same .5 percent interest rate.
Determining Rates
Car dealers work with lenders to determine interest rates that will attract buyers. In some cases dealers and lenders will offer special low interest rates on specific models, such as those in surplus or those about to be replaced by a new model. In other cases lenders will reserve their lowest rates for buyers with strong credit scores since they represent less of a lending risk. A lower interest rate means a smaller monthly finance charge and overall savings.
Cost and Savings
You can use a web-based loan calculator to determine your total finance charges over the life of a loan. These programs allow you to enter the amount you owe, your interest rate and the term of the loan to compute the total cost of borrowing. Of course, you can reduce this cost by making the largest possible down payment, or making payments above the amount due each month. The extra money will go toward reducing your principal balance and future payments.
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