Buying a car is an involved process that takes on an added dimension when you choose to finance rather than pay cash. Financing a car means you'll need to go through the process of securing a loan. Some aspects of auto loans are straightforward, such as the understanding that a lower interest rate means it will cost less to borrow the money. But other aspects, including loan value and loan-to-value ratio, are not always as clear.
Value for Lenders
Lenders use loan value as a measure of how much they are willing to offer a borrower in an auto financing arrangement. Loan value for lenders takes the borrower's credit history and down payment into account, along with the market value of the car. Each lender has its own method for determining loan value, but in every case the loan value is a balance between the risks of lending and the profits that lenders make by charging interest. Lenders use loan value metrics to determine the dollar amount of a loan, but loan value is not the same as the loan amount.
Value for Borrowers
When you take out a loan to buy a new or used car, the initial value of the loan is the amount you borrow. For example, if you purchase a new car for $25,000 and make a $5,000 down payment, your loan value will be $20,000. This is the amount you would need to pay the lender immediately to eliminate your loan.
Over time the value of your auto loan will change. This happens when the lender charges you interest and when you make payments to reduce the amount you owe. If you make larger payments, your loan value will decrease more quickly than if you make lower monthly payments. Missing a payment means your loan value will increase from one month to the next since you will still incur a finance charge and possibly a late payment fee.
Loan-to-Value Ratio
Another important number to look at when you finance a car is the changing loan-to-value ration. This represents the value of your loan as a proportion of the value of the vehicle itself. The value of your car will change as it depreciates and if it experiences any accidents or natural wear and tear. Some care depreciate more quickly than others based on desirability and supply in the resale market.
If your $25,000 car with a $20,000 loan value depreciates to a market value of $15,000 one year later, and you still owe $15,000 to the lender, the loan-to-value ratio is 1:1. However, if the car depreciates to just $13,000 while you still owe $15,000, you will have a loan-to-value ratio of 1.15:1. Any ratio above 1:1 means you owe more than your car is worth.
Considerations
A loan-to-value ratio over 1:1 can be a problem in some situations. Your auto insurance only covers your car for its market value, not its loan value. This means that is your car is stolen or involved in an accident such that the cost of repairs exceeds its market value, you will only receive a check for the car's market value from your insurance company. A $15,000 check won't be enough to pay off the $20,000 you owe, and you'll be responsible for the remaining $5,000 yourself. Gap insurance covers the difference between loan value and market value while your car is new and you still owe the majority of the initial loan value. A larger down payment will also help you avoid owing additional money by reducing your loan value to a level below your car's future market value.
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