How Do Car Payments Work?

Understanding how car payments work can prevent you from getting into debt over your head by taking on a bigger auto loan than you can afford. Your interest charges, down payment, the length of your loan term and the purchase price all affect how much you pay each month on an auto loan.

Payment Distribution

Your monthly car payment pays off your auto loan in two parts. A percentage of your payment goes toward the interest charge, which is the amount lenders charge borrowers to use their money to pay for cars or other things. The other part of your payment is applied to the principal, which is the amount of money you borrowed to pay for your vehicle. Borrowers usually pay car loans over 36, 48 or 60 months. The longer you take to repay your loan, the more it costs, because you pay more interest charges over a longer period.

Principal and Interest

The total amount of your monthly car payment generally remains the same, but your principal and interest payments fluctuate. Most of your payment goes toward interest charges when your loan is new. However, your principal also decreases with each payment, so the amount you pay in interest charges drops over time due to a lower loan balance. As a result, you pay more of the principal and less interest as your car loan ages.

Down Payments

The size of your down payment affects the overall cost of your loan. Some auto lenders dont require a down payment from people who have excellent credit ratings. However, paying down as much of the purchase price as possible and getting a loan to cover the remaining balance may prevent you from being upside-down in your auto loan. Borrowers are upside-down in a car loan when they owe more on their vehicle than its worth. Cars usually drop in value shortly after purchase, so a bigger down payment can prevent you from owing more than your vehicle is worth as its value drops.

Loan Term

A short-term loan of 36 to 48 months comes with higher monthly payments. However, paying off a loan as quickly as possible also can prevent upside-down loan problems. For example, your auto insurer will only pay you an amount equal to the value of your car if its totaled in a traffic accident. Thats less of a problem if your vehicle is mostly paid off at the time of the accident. However, a long-term loan could leave you upside-down in a loan if you have to continue to pay off a vehicle you can no longer use after an accident.