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You may be ready to drive off with a new set of wheels, but your bank balance might say otherwise. Getting a car loan is just one of the ways you can finance a new car. However, if you have never taken out car finance before, it can be a bit confusing. In this article we give an example of a car loan, breaking down how interest rates work, how to calculate APR and how to work out monthly payments.
For more on the different finance options available, check out our car buyer’s guide to car loan financing.
What is a car loan?
A car loan is essentially a personal loan. It doesn’t have to be a specific ‘car loan’. Any sort of unsecured personal loan would do. And like any other loan, it involves you borrowing a certain amount of money and repaying it over a set period of time.
Using a car loan can work in your favour in that you own the car outright from the very start. By taking out the loan you essentially become a cash buyer.
However, there are drawbacks. Firstly, you may be tied into monthly payments for longer than some other car finance options. Secondly, cars depreciate in value over time. But even though the value of your car has reduced, you will still need to repay your loan in full.
How do car loan interest rates work?
Like any other loan, your car loan will have an interest rate attached to it. The interest rate is the cost of borrowing.
So for an easy example, let’s say you borrow £1,000 at an annual interest rate of 10%. This means that you will need to pay back £1,000, plus 10% interest (£100). So the full amount you will need to repay after one year would be £1,100.
However, when buying a car, you will typically put down a deposit. You will only need a loan for what is left to pay on the price of the car.
Also, the term of a car loan is typically longer than just the one year used in our example. It is more likely to be two to five years. If you are comparing loans, try to find the lowest APR and compare what your monthly payments would be.
Not sure what APR is or how to work out your monthly payments? Let’s break it down.
What does APR mean?
APR is the annual percentage rate. This is the total cost of borrowing for one year. It is a useful benchmark for comparing loan products, as it includes the interest rate as well as any fees that are automatically added to the loan, such as arrangement fees.
Different providers calculate interest in different ways. You may find that some do it daily, while others do it monthly or annually. This can make it hard to compare the real cost of borrowing.
So the APR is there to clear that up. Whether the interest is charged daily, monthly or annually, the APR will show you what the annual cost of borrowing is. This makes it easier to compare loans like for like.
How can I calculate my monthly payments?
The key part of any loan is making sure you can afford your monthly repayments. Missing one can have a disastrous impact on your credit score. It is best to calculate how much you will be paying each month and for how long.
Car loan providers generally calculate loans so that you repay the same amount each month. So the interest cost is spread evenly across the loan.
To calculate what your monthly payment will be, you need to divide the APR by 12. Taking our earlier example, if you had an APR of 10%, the monthly cost over a year would be 0.83%.
Obviously, the length of the loan will impact how much you pay overall. One of the benefits of a car loan is that they are relatively flexible. You can choose a term from one year up to seven years. However, the longer the term, the more interest you will pay.
So, for example, if you had a £10,000 car loan at 10% over a one-year term, you would make 12 monthly repayments of £877.16. The total amount payment would be £10,525.87, so you would pay £525.87 in interest.
However, if you had a £10,000 loan at 10% over a three-year term, you would make 36 monthly repayments of £320.65. The total amount payable would be £11,543.47, meaning you would pay £1,543.47 in interest.
As you can see, while a longer term can bring your monthly repayments down, the total cost of borrowing will be higher in the long run.
For more information on buying a car with a loan, check out this valuable advice from the Money Advice Service.
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