Anatomy of an Auto Loan

Jones Pontiac/Honda, Lancaster, Pennsylvania, 1980

If you are considering buying a car, you are not alone. Statistics from the U.S. Census Bureau report that 21 billion cars were purchased from auto dealerships during 2010. Few of us have access to enough cash to pay outright for a vehicle, and thus we finance the bulk of our cars’ sticker prices. If an auto loan interests you then you need to consider four elements that impact your monthly car payment: the down payment, credit score, interest rate, and terms.

Down Payment

Most auto dealerships expect a cash down payment on a new or used vehicle. In sounder economic times, 20% of the car’s total price was commonly paid in cash. There is no legal requirement for a down payment, however, and auto dealers report that a 10% down payment is typical today. The amount you choose to pay directly affects your monthly payment; a larger down payment ensures smaller monthly bills.

Auto dealers often advertise financing that is available without a down payment. While this may be tempting, remember that you will be paying interest and fees on every dollar that you borrow to pay for the car. Many car buyers do not understand the impact of a down payment over the long term; reducing the principal amount of a loan before taxes and fees are added can significantly lower your total cost over time.

Vehicle trade-in is a popular first step in financing a new car, sometimes in place of a cash down payment. A car dealership assesses the resale value of an older car and quotes you the amount they are willing to pay you for it. If you accept the offering price, the trade-in value of your car is deducted from the loan principal.

The trade-in value of an older car is estimated by auto dealers using the Kelley Blue Book, an industry standard for valuation. However, other factors come into play, and your car’s trade-in value may not equal the Blue Book recommendation. Variables include the condition of the car and how well it is maintained, the inventory on the dealer’s used car lot that particular day, or even internal sales incentives for your sales representatives. In some cases, you may receive more money from your old car if you sell it on the open market yourself. Shop around for the most lucrative way to use your old car as a source of down payment.

Credit Score

After down payment or traded-in value is deducted, the remaining cost of the car must be financed. To identify the terms of the loan you are extending, lenders first look at your credit score. Three major credit reporting agencies (TransUnion, Experion and Equifax) compile historical data about your bill-paying habits, and lenders analyze this information before offering you an auto loan.

The most common scoring methodology is the Fair, Isaac & Co. (FICO) scores. Five different types of data are extrapolated from your credit history and weighed. This information helps lenders mathematically predict the likelihood that you will make regular and timely car payments.

  • Payment history: Representing about a third of your potential creditworthiness, your credit report is scrutinized for late payments. Credit reports with numerous late payments will result in a lower FICO score. Late payments in recent history are especially damning to auto loan shoppers.
  • Outstanding balances: Almost another third of the data that comprises your FICO score is the amount you currently owe other creditors. Remaining balances on other loans are not automatic strikes against you, but large balances that are disproportionate to your income will hurt you. Credit lines that are at or near their maximum limit also lower your score.
  • Length of history: About 15% of your credit history is tied to the length of time you have held and maintained credit. If you are have not established much credit because you are young, only time can offset this percentage.
  • New credit: The appearance of several new lines of credit within a short time frame is a red flag, and accounts for about 10% of your credit rating.
  • Type of credit: The last tenth of your credit report is extrapolated from the type of credit that you’ve had in your lifetime. Potential lenders analyze mortgage loans, revolving lines of credit, installment loans and retail account credit cards.

FICO scores range from 300 to 850. The higher your score, the more likely it is that you are offered credit and the opportunity to pay it back at low interest rates. Any score over 720 is considered an excellent score; scores under 650 are considered sub-prime and indicate high borrower risk. Subprime credit scores make it difficult to acquire loans and almost guarantee higher interest rates.

Interest Rate

The third component of an auto loan is the interest rate. A common misconception is that the loan interest rate and the annual percentage rate (APR) are the same; in fact, they are very different numbers. The interest rate is a percentage of the principal loan that you repay the lender for the privilege of borrowing the money. This percentage is based on fixed market indices and your credit score.

The APR is the cost of the loan over a year’s time, which includes the interest and all other fees and charges that are built into the loan. The APR is the single most important variable when comparing auto loans because it is an accurate reflection of what comes out of your pocket over 12 months. Use this figure to make accurate side-by-side comparisons prior to a final decision.

Numerous fees and charges are built into auto loans. In addition to simple interest and the cost of the car, fees that may be included could be document preparation fees, title fees, filing fees, warranty charges, dealer profit from wholesale purchase or the sales representative’s commission. Even if you have extremely good credit and a dealership offers 0% financing, that does not equate to 0% APR. The cost of providing you a loan must still be covered.


The final component of your auto loan is the payment term. Standard terms are monthly payments for 3 to 5 years. Longer loans feature lower payments, but since it takes longer to pay off the principal the more interest is paid to the lender. Shorter loans may have higher monthly payments, but the amount of interest paid over the life of the loan will be much less than a long-term loan. It is recommended that your car payment equal less than 20% of your monthly net income.

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