Car Loan Basics for First Time Car Buyers

A Car Loan Story

David, 17, recently graduated from high school, landed a good paying job, and wanted to buy a new car.

His thought was that he would go to his neighborhood Ford dealer where he had been admiring a bright red Focus model that he felt he could afford, and arrange for a convenient loan to pay for it. He could easily get approved for the loan because his father knows the owner of the dealership.

The car cost $12,000 with discounts and rebates. He thought a 5 year (60 months) loan would be about right because he figured payments to be $200 a month ($12,000 divided by 60 months), which he could easily afford.

David was wrong — in many ways. Let’s see why.

So what’s wrong with David’s thinking?

Age Requirement
First, he must be at least 18 years old  to be legally responsible to sign contracts, including sales contracts and car loan agreements. He would have to show proof of age before signing.

Loan Approval
Second, ignoring the age problem for a moment, car dealers don’t approve loans or make loans, so it doesn’t matter that David’s dad knows the owner of the dealership. Dealers work with banks and finance companies to arrange loans for customers. It’s the bank or finance company who approves loan applications and grants loans. Dealers sometimes “screen” customers as preliminary way to weed out customers who have impossible credit.

Credit History
Next, having recently graduated and just getting a new job, David does not have an established credit history. He has never had a credit card, department store account, or a loan. The fact that he has a new job doesn’t help if he’s been working less than 6 months.

If he was old enough (18 or older, see above), he could get a family member to co-sign the loan agreement, which would help him get approved. A co-signer would be responsible only if David fails to pay on his loan.

But since David is not yet 18, he can either wait until he becomes of legal age, or he could have his parents buy a car in their name and add him to their insurance policy as the regular driver.

Calculating Payments
Finally, David doesn’t understand how car loan payments are calculated. It’s not a simple matter of dividing the car’s cost by the number of months in the loan.

In fact, it’s a rather complex business math calculation that takes into account a monthly finance charge (interest), that will significantly increase his total cost, especially for loans 60 months long that have higher interest rates than shorter loans. The calculation must be performed with a business calculator or online auto loan calculator.

Length of Loan
Furthermore, even if David were to be able to get the car loan, a 60-month loan is too long for a teenager  who will become tired of his car long before 5 years is up. More than likely, his tastes will change and he’ll get future pay raises that will allow him to afford (want) better, more expensive cars.

Unfortunately, with such a long-term loan, he’ll be “upside down” for most of the term of the loan, making it financially troublesome to try to sell or trade before the loan is paid off. He may be tempted to trade and have the dealer roll his “negative equity” into a new car, which is not usually a good thing to do.

Other Costs
Further still, we wonder if David has considered the other costs of owning and driving a car. A car’s purchase cost is only a part of the overall cost of ownership. As a young male driver, his monthly insurance costs could easily exceed his loan payment amount. Then there’s gas, maintenance, repairs, tires, taxes, and license fees.

Summary
Unless someone buys a car for David, he should wait until he is at least 18 years old, has a stable income, has an established credit history, and understands how car buying and financing works.

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