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How Do Car Loans Work?

Believe it or not, your car is not a status symbol. Yup—we said it. Having a nice car doesn’t mean you’re a successful person, just like having an older car doesn’t mean you’re flat broke. If you’ve bought into that belief, you might be measuring success with the wrong end of the ruler.

Just about anyone can get a nice car (as long as they agree to a hefty car loan). These days, car loans are just viewed as a necessary step in the car-buying process. But if you have one eating up your money before the end of the month, it might just be time to start talking about how to get out of that car loan. So, how do car loans work?

How Do Car Loans Work?

Get this: According to Experian’s Q2 2020 State of the Automotive Finance Market report, almost 86% of Americans are purchasing new cars with auto loans.1 With so many people choosing to go into debt for their cars, you might assume they don’t know how car loans work. And that’s exactly how dealerships and lenders can get away with such high interest rates with even longer terms.

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The higher the interest rate and the longer the term, the more money your lender will get to stuff in their deep pockets. Why would you want to give the lender more than the car is worth? You wouldn’t! But we’re getting ahead of ourselves. What’s a car loan, and how does it work? Great question.

A car loan is made up of three main parts:

  1. Principal: This is the total amount of the loan (minus interest).

  2. Interest: Your lender’s favorite word. Interest is the amount of money your bank or lender tacks on to your bill each month in exchange for giving you their money.

  3. Term: This is the amount of time you have to pay back the loan.

Let’s say Sally wants to buy herself a new car. She got a great job right out of college and wants to upgrade her wheels to match her new title (big mistake). So, she does what most people do and finances the car rather than saving up the cash and paying for it in full.

Sally bought herself a brand-new SUV for $25,000 with no down payment. Yikes! Her lender gave her an 8% interest rate, and she promised to pay them back in a five-year term (or 60 monthly payments). But if Sally knew how car loans work, she may have said no to that monthly payment of $507. Ouch. We hope Sally’s new budget is big enough to cover her mountain of a payment for the next five years.

If you have a big car loan like Sally, it hurts you in the long term (not to mention right now). Let’s say you took out the loan we just talked about. You would pay over $30,000 for a $25,000 car. Yikes. Would you pay $300 for a $200 leather jacket? Of course not. Don't pay more for a car than it's actually worth.

And get this—if you have a paid-for car and were to invest that monthly car payment of $507 in a mutual fund for the next four years at a 10% interest rate, you’d have $31,059, which would allow you to buy an even better car . . . with cash!

In the meantime, don't jeopardize your family's well-being or your future just for a stupid car.

Does Your Car Loan Own You?

Here’s the scoop. The total value of all your vehicles (including boats, dune buggies, four wheelers . . . in other words, anything with a motor in it) should not equal more than half of your gross income. If you have that much of your money tied up in transportation, your budget for things like your rent or mortgage payment and food will be stretched way too thin. At that point, it doesn't matter how nice the car is, because it owns you and your life.

According to Experian’s Q2 2020 State of the Automotive Finance Market report, nearly 40% of new car loans are for five- to six-year terms.2 And since Sally bought the car brand new, by the time her loan runs out the car will have lost between 60% and 70% of its value. Crazy, right?

How to Get Out of a Car Loan

Now that you know the truth, let’s talk about how to get you out of that car loan. The way we see it, you’ve got two options:

1. Pay off the loan.

After all, you did sign your name on the dotted line. It’s time to get gazelle intense and work harder than you’ve ever worked before to pay this off as fast as you can.

This means your dinners should be beans and rice (and rice and beans) until you kick the loan to the curb. But this isn’t the best option for everyone. If you’re stuck with a loan that’s quickly eating up most of your income, it might be time to think about selling the car. 

2. Sell the car.

Check out Kelley Blue Book to find out how much your car is currently worth. Then, start spreading the word! Craigslist, social media sites and word of mouth go a long way toward making a private sale. But if you’re upside down on the loan, that’s a different story.

When it comes to your car’s value, time is not on your side—especially if you bought it brand new off the lot. And if your car loan is worth more than the value of your car, you’ve got to pony up the difference. If you don’t have the cash to pay off the loan and get the title from the lender, you may have to get an unsecured loan, pay off the difference, and then attack that loan with everything you have.  

Should You Get a Car Loan?

We’ve said it before, and we’ll say it again: No! Car loans are a bad investment—for absolutely everyone. Remember: If you can’t pay for that car in full, you can’t afford it!

Hey, what if you could stick that payment in your bank account instead of handing it over to a dealer every month? Awesome, right? Well, guess what? Being the one in charge of your money isn't a pipe dream—it's a goal you can actually reach. Learn how with a Ramsey+ membership. You'll get access to our bestselling online courses about managing your money and the tools you need to make it happen. It's about those small wins that lead to big results—and the first win is trying Ramsey+ in a free trial. Today!

Ramsey Solutions

About the author

Ramsey Solutions

Ramsey Solutions has been committed to helping people regain control of their money, build wealth, grow their leadership skills, and enhance their lives through personal development since 1992. Millions of people have used our financial advice through 22 books (including 12 national bestsellers) published by Ramsey Press, as well as two syndicated radio shows and 10 podcasts, which have over 17 million weekly listeners.

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