Auto Loans 101

bankofamerica Auto Loans 101 Image courtesy of Paul_Lowry http://www.flickr.com/photos/paul_lowry/2752153842/

Just about everyone in the United States of America has at least a very basic grasp on auto loans, but that may be about where the understanding ends.  This is akin to understanding gravity enough to know that you can jump and you will come down, but getting an auto loan is like needing to send a man to the moon; a basic grasp is only going to yield the most simplistic of results.  That could translate into a less than optimal loan, and that is certainly not a goal worth striving for.

Auto Lenders Like Credit

Auto lenders, like other types of lenders, are looking for credit-worthy people to lend money to.  Why does creditworthiness make or break a deal ?  Well, a lender operates on a very small margin.  You might think that a few percent on a loan is a big deal, but consider depreciation as well.  On average the buying power of the dollar will decrease by roughly 3% each year when looking at any broad period.  This means that a loan at 6% really yields a roughly 3% reward.

Consider the example of a $5000 loan over the period of 5 years at 6 percent.  The total repayment on that loan is $5799.60 for a net gain of just under $800.  Take that same loan but use 3% for the calculation as 6% minus the annual inflation average and you wind up with a net gain of just over $390.40 that will have depreciated to a degree after receipt and will actually be worth far less in terms of spending power at the end of the loan than the beginning of the loan.

So how does credit figure in?  Well, lenders have bills to pay too and like you they get hit with late fees and interest on past due obligations.  Therefore, it only makes sense that they do everything in their power to ensure that they have a steady and reliable stream of income, much like you would count on your work to provide you with a paycheck on the correct dates each and every time.  Just imagine the kinds of problems that you might experience if your work suddenly decided that it could not pay you on time and would need to pay you 10 days late!  You might be evicted, you might miss credit card payments, your utilities might be shut off, etc.  There are many possible consequences, and a lender is subject to a very similar set of consequences when payments from auto loans they issue do not come in on time; they may not be able to make payroll, mortgage, pay utilities, etc.  Most lenders can get short term loans with interest and fees to cover these expenses, but that further diminishes their returns.

How to Fix or Build Credit

Bad credit is surprisingly easy to fix, and many can go about it in much the same way as they do building new credit: start with getting credit cards, secured if necessary, and opening a few store accounts.  Treat these cards and accounts responsibly by paying them on time every month, but be sure to use them or the issuer may close them down.  Do not run them up, however, as this may cause your credit to decline.  Remember, the idea of credit is to show that you spend and pay back money in a responsible fashion.

Terms

It might seem like a great idea to go for a 6 year loan instead of a 5 year loan, but do the math.  Calculate the number of payments times the payment and you may find that the deal is not as great as it first seemed.  For example, our $5000 loan at 6% spread over 5 years is $96.66 per month but would only be $82.86 over a 6 year period.  So a six year loan seems like a great way to save some money right?  Do the math and you will see that a 5 year loan will cost you $5799.60 while the same loan at 6 years will cost $5965.92, a difference of $166.32.  You might scoff and think that $166.32 is not much, but if somebody offered it to you for free you would certainly not object, and yet that is exactly what this; the lender is offering to save you money with a shorter term loan repayment and all they want in exchange is an extra $13.80 each month.

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