What is a Car Loan?

A lot of people try to avoid debt like the plague (which isn’t a particularly bad idea). They try their hardest to pay for everything themselves and ensure that they don’t get stuck worrying about interest rates and defaults. While this strategy might work for a while, most of us will eventually run into a necessary purchase that we simply don’t have the money for. It may be a dream house or our university expenses, but regardless of the details, we find ourselves in a position where loans are more or less unavoidable. Auto Loans are no exception. Few people can just walk into a dealership and purchase a new car – they need financial support and that means getting a loan.  But what does this really entail? What is a Car Loan? And how does it work?

As with any other advance, a car loan involves borrowing money from a lender (usually the bank) and using it to purchase your vehicle. You are then required to make monthly payments back to the lender (with interest) until you have paid off your debt. 

There are, however, one or two major factors that differentiate car loans from other kinds of advances.  

What is a Car Loan?
What is a Car Loan?

How Do Car Loans Work?

Unlike most personal loans, car loans are secured with collateral. In other words, when you take out a car loan, the car itself will be used as security. If you are unable to pay back the money that you owe, the bank will repossess the car and sell it in order to mitigate their losses. 

This collateral means that car loans are often seen as safer investments by banks which usually means that their interest rates will be lower than other, unsecured loans. It also means that you should be eligible for a car loan even if you have a less-than-stellar credit score, although a better credit score will still get you a better deal overall. 

Another big difference to note is that car loans are specifically given out for the purchase of vehicles. By contrast, personal loans may be used at the discretion of the individual. You may use them to purchase a car, a boat, renovations, etc. Car loans, on the other hand, are only to be used for purchasing cars.

Is a Financial Plan a Good Idea?

Unfortunately, there’s no one-size-fits-all answer to this question. Figuring out whether or not a car loan is a good idea is going to come down to your personal financial situation and will depend heavily on your available options. 

If you’re trying to figure out if a car loan is a right move for you, consider the following points – 

Is it Necessary? – A car can be anything from a convenience to a vital necessity. If you’re getting along fine right now without a car, but having one would make things simpler, make sure you’re financially stable and strong enough to take that hit. On the other hand, maybe you desperately need a car to get to work and there are no other means of travel available to you. In such a scenario, perhaps there’s no way of getting around a car loan. 
Are there Other Options? – Getting a loan isn’t the only way to get behind the wheel. Take the time to research leasing and see if that isn’t a more viable option. Also, if you work from home and don’t travel around very frequently, it may even be better to use a ride-hailing service like Uber rather than actually buying a car. 
Can you use Cash? – Spending such a big chunk of cash all at once may be scary, but there are multiple benefits to purchasing a car outright rather than taking out a loan. Most importantly, you will end up paying less overall because you won’t be constantly paying interest to the lender. That said, just because you can technically make the purchase doesn’t mean that you should. If buying the vehicle will leave you with virtually no money in your bank account, you can’t really ‘afford’ it.  
Can you Afford the Extra Costs? – Any person who owns a car can tell you that the spending doesn’t end with the initial purchase. Even if you can afford to pay back your loan, maybe you’ll struggle to pay for insurance and all the maintenance that comes along with a vehicle. Remember, there’s no point in buying a car if you can’t afford to put petrol into it. 

What is a Car Loan an Example of?

A car loan is a great example of a secured, fixed-rate loan used specifically to purchase a vehicle. 

In simpler terms, a car loan is a type of advance that is backed up with collateral (the car itself) and that has a stable interest rate that will not increase or decrease during the loan period. Additionally, this loan cannot just be used for any purchases that the individual desires and must instead be used only for the vehicle in question. 

What is a Car Loan?
What is a Car Loan?

Can You Pay Off a Car Loan Early and is it Smart to do so?

Yes, you normally can, and it’s usually a great idea. Because of the interest over time, your car loan will end up being a lot more expensive than the car itself. 

The less principal you have to pay on the car, the less the interest is going to affect you. So by making extra payments when possible, you’ll be taking chunks out of your initial cost and lowering the overall interest that’s due. 

The quicker you do all this, the more money you’ll end up saving in the long run, but that doesn’t mean you should rush out and use all your savings on it just yet.

It may be tempting to get rid of your debt ASAP, but you need to make sure that you can actually afford to spend that extra money. Additionally, your bank may include certain penalties for early repayments, although these costs are usually less than the amount of interest you’ll end up incurring.    

Can You Pay Off a 72 Month Car Loan Early?

Yes, you normally can, and it’s usually important that you do so. 

As mentioned, the interest on your car loan will result in you paying more than was initially required for the car itself. When you take out your loan, you will normally be given multiple options for your repayment period

The shorter the repayment period is (say 12 months), the more expensive your monthly payments will be. It may sound like it’s better to take a longer repayment period, but be careful, the longer your repayment period is, the more you’ll end up spending on interest. 

With a 72-month repayment period, you’re going to end up spending a huge amount of money on the interest alone so it’s a good idea to pay off the principal early and lessen that financial burden. 

In Conclusion – What is a Car Loan and How Does it Work?

A car loan is an advance given by a lender (usually the bank) which allows you to purchase a vehicle. The amount given will then need to be paid back, with interest, over an agreed-upon period of time. Car loans differ from personal loans in the sense that they are secured (with the car itself being used as collateral) and designated for the vehicle purchase itself rather than for the general whims of the individual. Additionally, car loans tend to have lower interest rates which are also fixed for the duration of the loan repayment period. 

What is a Car Loan?

A car loan can be a worthwhile investment in certain circumstances. If, for example, you desperately require a vehicle to get to work and you simply cannot afford to pay for it yourself, a car loan may enable you to make the purchase without causing too much financial strain. 

That said, car loans do end up being more expensive over time than the initial vehicle price due to the interest rates attached to them. As a result, a person who can comfortably purchase a car without a loan or someone who doesn’t particularly need a car should think twice before taking out a loan. 

You are generally allowed to pay back a car loan early if you are able to do so. This is normally a great idea as payments towards the principal amount will reduce the overall interest that you pay. In other words, the sooner you pay off your principal, the less money you will end up spending on the loan. That said, there may be certain penalties attached to early loan repayments. Lastly, it is important to remember that longer repayment periods result in cheaper monthly payments but a larger final cost, so it is usually more prudent to pay more money each month and get your debts out of the way than to prolong the process. 

Disclaimer Finance101: All of our posts are for research purposes only. Finance 101 aims to assist its readers with useful information on the laws of our country that can guide you to make financial decisions that will enable you to become more financially independent in the future. Although our posts cite the constitution in many instances, they are intended to assist readers who are looking to expand their knowledge of the law & finance-related queries. Should you require specific legal/financial advice we advise you to get in touch with a qualified financial expert.

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