College is a time when many students purchase their first car. Not surprisingly, college students also tend to have below-average credit scores and credit histories. This makes college students prime targets for predatory lending and bad auto loans!
Having a short credit history or low credit score makes obtaining an auto loan difficult but not impossible. There are plenty of lenders willing to offer auto loans to students with such credit, however, the terms of those loans are usually very unfavorable.
Because a financing contract is like any other legally-binding contract, a person must repay an auto loan on whatever terms they signed and agreed to. So the best thing a student can do before car shopping is to educate themselves on auto loans and which loans not to sign.
Interest Rates
It is common knowledge that lower interest rates are better than higher interest rates. But students should know they have some power in negotiating lower interest rates and should be shopping around to compare rates from different lenders.
A simple illustration to highlight the importance of interest:
An auto loan for $10,000 over 48 months at 6% interest:
- Monthly payments of $234.85/month, and a total amount paid of $11,272.80
An auto loan for $10,000 over 48 months at 19% interest:
- Monthly payments of $299.00/month, and a total amount paid of $14,352.00
I do not know about you, but that difference of $3,079.20 is a large amount of money! That could be a few months of rent, multiple sets of new tires, or one or two textbooks (just kidding!).
Simple Interest vs. Pre-Computed Interest
Plainly put: avoid pre-computed interest loans and only take out simple interest loans.
In a simple interest loan, the interest on a loan is calculated based on the amount due at the time, not on the total amount taken out at the beginning of the loan. This means that if you decide you want to make extra car payments here and there, or if you have the chance to pay off your car loan early, you are able to without having to pay extra interest as a "penalty."
In a pre-computed loan, the lender will calculate how much interest you will pay over the course of the loan and you are on the hook for paying every cent of that amount. So if you take out a 36 month loan but try to pay it off early, you will still have to pay 36 months-worth of interest. While the federal government prohibits lenders from offering pre-computed interest loans that last longer than 5 years, the state of California still permits these types of loans if they are less than 5 years.
The easiest way to check if a potential loan has pre-computed interest is to look for terminology in the contract regarding a "rebate" or "refund" of interest if the loan is paid early, or some other kind of pre-payment penalty. Some pre-computed interest loans may explicitly reference the "Rule of 78s." While the Rule of 78s is difficult to explain, those words should be a large red flag to students!
Pre-computed interest loans can be tricky, especially if a student wants to pay off the loan early and is seeking a "rebate" or "refund" as mentioned in the contract. UC San Diego students in this situation should make an appointment with Student Legal Services to discuss the pros and cons of paying off his or her loan early.
