You’ve done your research and found the perfect ride. You’ll want to line up financing options before you set foot in a dealership, and there are some terms that you should learn so that you fully understand the loan contract that you’re considering.
The first few terms define the loan itself, and you will hear others during the process of applying and signing your loan documents.
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Auto Loan: A contract between you and a lender in which they provide you with a sum of money to purchase a vehicle and in return you agree to pay that money back, plus a defined amount of interest. There may or may not be other fees stipulated in the contract. The lender holds title to the vehicle until the loan is paid off.
Interest Rate (also Annual Percentage Rate or APR): The interest rate is the cost of borrowing money, expressed as an annualized percentage of the loan that is added each year to cover your lender’s costs and provide their profit margin.
The average rate on a 48-month car loan is currently 3.4 percent, according to Bankrate. Rates vary daily and are affected by your personal credit history, the terms of the loan, and the vehicle that you are purchasing. There are often financing deals available from auto manufacturers to boost sales of select new vehicles. These financing deals are typically low- or no-interest loans, but you have to meet a certain credit threshold to qualify for them.
Interest (or Finance Charge): The total amount added during the term of the loan to cover the lender's cost and profit margin. Determining the total interest (and other details of the loan) requires a financial calculator.
For example: On a $20,000 loan at 4 percent with a 48-month term, you would pay a finance charge of $1,675.89 over the life of the loan. Over those four years you would be required to pay a total of $21,675.89.
Term: The length of the loan, which will be presented by the lender as a number of months. Typical loan terms used to be 48 and 60 months, but terms of 72 to 96 months are becoming common as vehicles get more expensive. You should divide the loan term by 12 to find out how many years you will be paying off the loan.
The longer the loan term, the more inherent risk there is for the lender, so the interest rate will likely be higher on a longer-term loan.
Principal: The loan balance in dollars. On day one, the principal amount will be the amount that you borrowed. As you make payments, the principal balance will go down. A portion of each payment you make goes to cover that period’s interest, while the rest of the payment reduces your principal balance.
Payment: How much you need to pay the lender on a periodic basis to pay the interest and reduce the loan principal. The payment is determined by entering the term, principal, and interest rate into a financial calculator, like the one you’ll find at U.S. News & World Report’s Best Cars site.
Rebate: A special offer, generally offered by a manufacturer, designed to increase sales of a certain model of vehicle. You can usually take the offer as cash back after a purchase or apply it to your down payment.
Down Payment: The amount of cash plus the value of the trade-in that you bring to the transaction and any available rebates that you apply to the purchase. The cost of the vehicle minus the down payment equals the initial principal amount of the loan. Larger down payments can dramatically lower the monthly payment on the loan or allow you to reduce the term of the loan.
Terms You’ll Hear During the Application Process
When you’re applying, you will hear a number of other terms that you should be familiar with. You’ll also hear about a number of ratios that are used to determine your eligibility and the terms of any loan you may be offered.
Credit Score: A number provided by a credit bureau or other score producer that represents your credit history and risk. The credit bureaus and other credit score producers use proprietary formulas and information from your credit report to determine your creditworthiness. Lenders purchase these scores to help determine the terms of any loan offers. They’re often, incorrectly, referred to as FICO Scores because FICO (short for Fair Isaac Corporation) is one company that generates scores.
What’s a good credit score? There’s no easy answer, as every lender judges the score differently and every credit score producer uses a slightly different method to determine the number. In general, a FICO score or VantageScore of 750 or more is considered excellent, and below 600 is classified as bad credit.
Credit Report: A credit report is the comprehensive documentation of your credit history that is used to determine your credit score. You are entitled to a free credit report each year from each of the three major credit reporting bureaus – Equifax, Experian, and TransUnion. Before applying for a loan, you should check your credit reports and work to fix any incorrect information in them.
Debt-to-Income Ratio: The ratio of your monthly debt payments to your gross monthly income. Your debt payments generally include house, car, and student loan payments, plus child support and any other monthly contractual debt obligations that you have.
Divide your total monthly debt by your monthly gross income to come up with the ratio. Lenders like to see this number under 36, but even lower is better.
Loan-to-Value Ratio (or LTV): Simply the ratio of your loan amount to the value of the vehicle that you are purchasing. If you put 20 percent down on your new car, you will have an 80 percent LTV. The higher the LTV, the more risky the loan is to the lender and the higher the interest rate will likely be. An optimal LTV to get the best loan deal is 80 percent or below.
Some lenders will roll the amount of your current car loan into your new car loan creating an LTV ratio that is greater than 100 percent. Owing more on your car than it is worth on the day that you take delivery is risky, and your loan will be priced to include that risk to the lender. An LTV of greater than 100 is also called negative equity or being underwater on the loan.
Co-Signer: If you are personally not able to qualify for a loan, many lenders will allow you or encourage you to have another person who does qualify also sign the loan documents. Your co-signer would then be just as legally obligated as you to ensure that the loan terms are met. If you go into default, they could be responsible for the entire remaining balance of the loan.
Equity: The difference between your loan balance and the amount you can sell the car for (its market value). It’s best when this number is positive, especially at trade-in time when you can roll that equity into the down payment on your next car. When this number is negative, it is not a good thing, as you are still responsible for paying the entire loan balance, even if you sell the car for a lesser amount.
Blue Book Value: Named for Kelley Blue Book, the Blue Book value is an estimation of your car’s market value based on what similar vehicles in the market are selling for. The value varies based on the condition and mileage of your car and whether you are selling it to a private party, trading it to a dealership, or using it for guidance on purchasing a used car. Edmunds and NADAguides.com are other commonly used sources for used car values.
Certificate of Title (or Title, Pink Slip): A title is a legal document showing that you own a car outright. If you take out a loan, you will not receive title to the vehicle until the loan is paid off. If you are trying to sell your car, you will need to have proof of title before you can do so.
Proof of Insurance: Nearly every lender will require you to have proof of insurance before granting you a loan and throughout the life of the loan. Failure to provide proof of insurance will trigger a clause in the loan that allows the lender to purchase insurance on your vehicle and charge you for it. Insurance purchased by the lender to protect the loan is very expensive and should be avoided at all costs.
Truth in Lending Act (or TILA, Regulation Z): The Truth in Lending Act is the basis for a federal regulation that requires standardized methods for presenting consumers with information about the terms of many kinds of loans, including auto loans. TILA allows consumers to compare the APRs offered by different lenders on a level playing field, knowing that they were derived using legally required practices.
Bad Credit: Bad credit creates challenges for consumers trying to get car loans. Factors leading to this condition include low credit scores, past repossessions or other losses caused to lenders, bankruptcy, and errors on credit reports. You can actively work to repair errors in your credit reports. Time is the best cure for the other items on the list.
Subprime Borrower: A borrower with bad credit, one that has had many jobs in a short period of time, or one that the lender does not feel has the capacity to repay the loan (within legal parameters of what a lender is allowed to consider). Lenders see subprime borrowers as more likely to default, so loan terms will generally be shorter with higher interest rates and lower loan-to-value ratios.
Terms You Don't Want to Hear
Finally, there are some terms that you don’t ever want to become familiar with but you might hear during the auto lending process.
Upside-Down (or Underwater, Negative Equity): Being upside-down on your car loan doesn’t have anything to do with your driving skills. Instead, it describes a condition in which you owe more on your loan than your car is worth. If you total the car while you have negative equity, you are still responsible for repaying the entire loan balance.
Late Payment: When you have not made your contractually obligated payment on time, you are subject not only to interest that continues to accrue, but also to late fees. You can avoid having accidental late payments by choosing to pay your loan automatically each period, either from a payroll deduction or a transfer from a bank or credit union account to the loan account.
Delinquency: Officially, you are delinquent as soon as you miss a payment due date, unless your lender has a grace period on payments. Once you are considered delinquent, the lender can charge you late payment fees and potentially change the terms of the loan as outlined in your loan documents. Delinquency can also affect your credit score and your ability to get another loan in the future.
Default: After missing a number of payments or being a certain number of days overdue, your lender can declare your loan to be in default and pursue repossession of what is legally their property.
Repossession: Repossession is the process by which a lender reclaims what is legally their property. Unlike on reality television, most repossession professionals will simply knock on your door and demand the keys and access to the asset. In most states, if your loan balance is greater than the amount that the financial institution is able to recoup from the sale of the vehicle, you will be responsible for the difference.
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