How Auto Loans Work: Everything a Beginner Needs To Know

Filed in Loan by on November 14, 2020 0 Comments

This page covers all the important information on how auto loans work. Here you will learn what Auto loans are, the different types of auto loans, where to get auto loans, how to choose the best auto loans, best auto loan rates, auto loans application requirements and all other important auto loans information you may need. Stay tuned.

What Are Auto Loans and How They Work?

Auto loans are secured loans that use the car you are buying as collateral. You are usually required to pay a fixed interest rate and a monthly payment for a period of 24 to 84 months, at which time your car will be paid off. Many dealerships offer their own financing, but you can also find auto loans at national banks, local credit unions, and online lenders.

Because auto loans are secured, they tend to come with lower interest rates than unsecured loan options like personal loans. The average APR for a new car is anywhere from 3.24 percent to 13.97 percent, depending on your credit score, while the average APR for a used car is 4.08 percent to 20.67 percent.

Types of Auto Loans?

While it is not uncommon for American drivers to buy used cars in cash-only private party transactions, most new car buyers use car loans to fund their rides. As the economy heats up, more Americans are taking out auto loans.

However, there are different types of auto loans. If you are new to the auto loan industry, be sure to check out the common and not very common types of car loans that exist.

Secured Auto Loans

Many auto loans are secured. This means that they are guaranteed by a lien on the underlying asset – in this case, the vehicle. If you fall behind on payments, your lender has the legal right to seize or repossess the vehicle. Once the loan is repaid, the lien is lifted and the lender no longer has the right to repossess the vehicle.

Since they are less risky for lenders, secured loans tend to carry lower interest rates than comparable unsecured loans. If the overriding concern is securing the lowest possible interest rate on your loan, seek out a secured option. However, bear in mind that other factors may affect your interest rates, such as your credit score and loan term.

Unsecured Auto Loans

Unlike secured auto loans, unsecured loans are not guaranteed by the underlying asset. Since lenders are not permitted to place liens on vehicles financed with unsecured loans, they can’t repossess them when borrowers become delinquent.

Due to greater lender risk, unsecured auto loans have higher interest rates than comparable secured loans. Your exact rate will depend on your credit profile and other factors.

Simple Interest Auto Loans

Simple interest loans’ outstanding balances accrue interest on a periodic basis, often daily. Borrowers must make monthly payments, but they can accelerate payoff and limit interest expenses by making larger or additional principal payments. Simple interest loans are therefore more flexible for borrowers with some breathing room.

If you have substantial personal savings or expect your cash flow to increase (perhaps due to a raise at work or falling household expenses) in the future, opting for a simple interest loan may reduce your total borrowing costs.

Pre-computed Auto Loans

Pre-computed loans are not as flexible as simple interest loans. Borrowers must make scheduled payments on a pre-determined basis with each payment assigned a precise share of the loan’s principal and interest. Accelerated payments don’t reduce the total principal and interest owed over the life of the loan — they merely front-load the payoff.

If you have a limited budget or anticipate an adverse change to your financial picture in the future, a pre-computed loan that allows for a predictable payment schedule may be your best choice.

Requirements for Auto Loans

If you need a car loan, the conditions you have to meet depend on whether or not you need a bad credit car loan. It is usually easier to get a loan if you have a good credit history. This does not mean that you cannot get a car loan with a bad credit history. Lenders just need you to meet a few basic car loan requirements first.

With good credit (credit scores above 660) you’re considered a low-risk borrower, and lenders aren’t as concerned with certain details. This is because borrowers with good credit have reported histories that already prove they’re responsible with credit.

Bad credit borrowers (credit scores below 600) however, have credit reports that show either a spotty history of late or missing payments, or not much credit history at all. Therefore, lenders require more information before approving them for a loan.

The items lenders require vary, but the basic car loan requirements tend to stay the same when you’re a bad credit borrower. Lenders that work with people in challenging credit situations are called subprime lenders. They know that it’s important to look at other factors in addition to credit scores to approve people with less than perfect credit.

The auto loan requirements that subprime lenders look for are:

Proof of income: Lenders need to see that you have steady, taxable income in the form of your most recent computer-generated check stub showing year-to-date income. For bad credit borrowers, lenders usually require a minimum income of $1,500 to $2,000 a month before taxes from a single job.

Proof of residence: A current utility bill in your name at the address listed on your application is typically sufficient for this.

Proof of identity: A valid driver’s license or state-issued photo ID is required. Even though not every lender requires a borrower to have a valid driver’s license for proof of identification, you do need one to register and drive off in a vehicle.

Proof of a working telephone: Some lenders have a saying: “no phone, no loan.” This may seem harsh, but lenders have to be able to contact you. A bill for a landline or contract cell phone in your name at the address listed on the application is required. Prepaid phones don’t count.

List of personal references: Lenders typically require a list of five to eight personal references, complete with names, addresses, phone numbers, and email addresses. Not all lenders contact your references, but require them to be on file, in case they need to verify information or can’t contact you.

Down payment: Bad credit lenders typically require a minimum down payment of at least $1,000 or 10% of the car’s selling price, whichever is less. Keep in mind this is just a minimum guideline, and your down payment requirement varies based on your credit, the vehicle you’re financing, the lender you’re working with, and more.

Whether you have good or bad credit, there are additional things that you should keep in mind when you’re financing a car. Items like tax, title, and license fees, dealer documentation fees, interest rates, and loan terms all impact the overall cost of financing.

Qualifying for a Car Loan with Bad Credit

You don’t need good credit to get a car loan. In fact, there are several auto lenders that specialize in working with borrowers with bad credit.

To get an auto loan with bad credit, take your time shopping around to find lenders that offer preapproval and can give you relatively decent terms. Also, try to have a good down payment or trade-in value to help reduce the amount you need to borrow.

Finally, consider getting a cosigner who has great credit and can help you qualify for a better auto loan. Just keep in mind that your cosigner is equally responsible for paying off the loan if you default, so it can ruin both your credit histories if you’re not careful.

Work On Your Credit before Applying

The better your credit situation, the higher your chances of getting approved for an auto loan with excellent terms. If you don’t need a new car quite yet, check your credit score to see where you stand, then focus on areas where you can improve.

For example, get caught up on any past-due payments and work on paying down credit card balances. Also, check your credit report for potential inaccuracies that you can dispute with the credit reporting agencies. Improving your credit can take time, but it’s well worth it if it can save you money.

How Do You Get a Car Loan?

The process of getting a car loan is similar to that of getting any other type of loan. Here are steps you need to take;

  1. Check your credit report and fix any errors. Your credit score determines what interest rate you’ll receive.
  2. Shop around at multiple lenders, including big banks, community banks, credit unions, and online lenders. Compare rates, terms, credit score requirements, and other factors.
  3. Apply and get preapproved for a loan from several lenders to see which offer is the best. Keep in mind that any credit inquires that take place within a 14- to 45-day period only count as a single inquiry on your credit, so it’s best to do all of your loan shopping within a short time span.
  4. Find your vehicle and compare the dealer’s financing offer to your preapproval offer.
  5. Finalize the offer with your lender, following instructions and filling out paperwork to complete the loan transaction. Ensure that the loan is what you’ve agreed upon. Check the APR, amount financed, and finance charge before you sign off on the loan.

What Is The Best Place to Get a Car Loan?

What is the best place to get a car loan? The answer varies based on each borrower’s needs, preferences and credit history. The good news is there are a variety of options out there to consider.

1. Dealer Financing

There are three common routes you can take when getting your car loan financed by a dealer.

(a) Dealer-arranged Financing

Dealers often have relationships with banks and other lending institutions. With dealer-arranged financing, the dealer connects you with one of its lending partners, acting as an intermediary in the financing process.

The big advantage of dealer-arranged financing is that it’s incredibly convenient. You don’t have to put any effort into finding a lender. From start to finish, the dealer supervises the process to help you find a loan.

Still, while dealer-arranged financing can simplify the process of finding a loan, you aren’t shopping around across a wide range of lenders to compare rates. This could result in your paying a higher interest rate than you would have if you’d done your own comparison shopping.

Another reason the interest rate may be higher is that lenders may include a fee to compensate the dealer for handling the financing process. As a result, you could wind up paying a higher interest rate than you would have if you’d chosen to deal with the lender directly.

One thing to note: After you buy a car, your loan might end up in the hands of the dealer, a lender or even a third party that purchases your loan. So your car payments could go to a different lender than you originally expected.

(b) Captive Finance Companies

Many of the larger carmakers have their own in-house financing divisions, called captive finance companies. Examples include Toyota Financial Services, GM Financial and Ford Credit. These companies may finance new vehicles or manufacturer-backed certified pre-owned cars.

When you’re buying a car at a dealership, the dealer may send your loan application to the captive finance company at the same time it reaches out to other lending partners. If you know the make and model of the car you plan to buy, you may also be able to apply online for a loan from a captive finance company before visiting the dealership.

Captive finance companies sometimes offer appealing promotional incentives, such as loans with 0% APR. But these deals may only available only to borrowers with strong credit.

(c) ‘Buy-here, Pay-here’ Financing

With “buy-here, pay-here” financing, the auto loan is financed in-house by the car dealership. The lender and the auto dealer are one and the same.

In this car-buying process, the dealership determines whether you’re eligible for a loan and, if so, how much. If you choose a car from the dealership and finalize the loan, payments are typically made directly to the dealership. The lender may place a device on your car that helps it locate or disable your car if you miss a monthly payment.

Buy-here, pay-here financing is often geared toward those with subprime credit. If your credit needs work and you’re struggling to get approved for a car loan, a buy-here, pay-here dealership could provide you an option.

But consider buy-here, pay-here dealerships a last resort. They typically charge the highest interest rates of all lenders out there, and some may also charge a bunch of fees. If you go this route, be sure to read the fine print so you really understand the total cost.

2. Banks

When dealing with banks, you have the opportunity to get preapproved for several car loans, compare rates and identify the best offer for you. Banks may advertise low or competitive interest rates but often only offer those to borrowers they define as having “excellent” credit.

Your bank financing options may also be limited by the type of car you want to buy. Some banks won’t finance cars over a certain age or mileage. If you plan to purchase an older used vehicle, you may have difficulty finding a bank that will give you a car loan.

3. Credit Unions

A credit union is a nonprofit organization that returns profits to its members through higher savings rates as well as lower fees and loan rates.

Membership comes with benefits. Credit unions generally offer lower interest rates than banks do. According to the National Credit Union Administration, the average credit union interest rate on a five-year new-car loan in the third quarter of 2018 was 3.37%, while the average rate for the same loan through a bank was 4.93%.

If you have poor credit, a credit union may be more flexible than a bank. Credit unions build relationships with their members that allow them to offer a more personalized experience.

4. Online Lenders

With online lenders, you can easily shop around and evaluate rates and loan terms from the comfort of your living room. In some cases, you can preview offers from various lenders on one site so you can easily compare loans side by side.

As with credit unions, some online lenders may be more willing to work with car shoppers with less-than-perfect credit. But these lenders may offer steep interest rates. Subprime borrowers can get charged interest rates on their car loans that reach as high as 25% or more. On the flip side, if you have good credit, an online lender might offer you a lower interest rate than you could get with a traditional bank.

With online lenders, customer service may vary drastically from company to company. Research the lender’s customer service history before signing on the dotted line. As with dealerships, banks and credit unions, you should check out reviews on sites such as Yelp, and be sure to check with the Better Business Bureau and Consumer Financial Protection Bureau to see if any complaints have been lodged against the company.

How to Pick the Right Lender for your Auto Loans?

Getting the right lender for your auto loans is the most important decision. There’s a lot to take into account when choosing an auto loan. Generally, your credit score will make the biggest impact in the rates offered. The higher your credit score, the lower APR you’ll receive.

Having a higher credit score may also allow you to take out a larger loan or access a broader selection of repayment terms. Choosing a longer repayment term will lower your monthly payments, although you’ll also pay more in interest overall.

First, it’s a good idea to check your credit score to see where you stand, then look for lenders that have considerable credit requirements to increase your chances of getting approved.

Before you sign a contract and drive off the lot, take some time to understand the pros and cons of different auto loan options, including banks, credit unions, online lenders and dealerships. Doing your research on different lenders will help you find the best possible loan offer for you.

The lender you choose should help you feel comfortable and knowledgeable about the debt consolidation loan process. You should look for a lender who will tell you in advance about the entire process of obtaining a loan, especially the requirements for obtaining a loan.

Clarity and visibility are necessary requirements for any financial partner. You should receive documentation on the requirements, rates and costs associated with your loan.

Best Auto Loans

Below, are seven lenders and companies offering some of the best auto loan rates. In order to compile this list, we looked at auto loan products from lenders and compared key factors including APRs, minimum loan amounts, repayment terms, credit score requirements, and other perks.

Company NameBest ForMin. Credit ScoreEstimated APRMin. Loan AmountMax Loan AmountTerm Length
PenFed Credit UnionOverallNot disclosedAs low as 1.39%$500$100,00036 to 84 months
Bank of AmericaAuto LoansNot disclosed As low as 2.59%$7,500 ($8,000 for Minn.)Not disclosed12 to 75 months
Consumers Credit UnionCredit UnionNot disclosedAs low as 2.69%NoneNone0 to 84 months
MyAutoLoanBad Credit575As low as 2.49%$8,000 ($5,000 for refinance)Not disclosed0 to 84 months
AutoPayRefinanceNot disclosedAs low as 1.99%$2,500$100,00024 to 84 months
LightstreamOnlineNot disclosedAs low as 2.49% $5,000$100,00024 to 84 months
CarvanaFair CreditNoneAs low as 3.9%NoneNot disclosed36 to 72 months

Frequently Asked Questions about Auto Loans

Who Has the Best Rates for Car Loans?

The company that is able to offer you the lowest rates for an auto loan can vary depending on where you live, your credit score, your employment history and other factors. Your best bet is shopping around among at least three auto lenders until you find the best deal.

Is a 72-month Car Loan a Bad Idea?

One problem with longer car loans is the fact that you often wind up “underwater” on your loan for the first few years. This is due to the fact that cars tend to depreciate faster than you can pay your loan off.

A 72-month car loan means you’re paying your loan off more slowly and have the potential to owe more than your car is worth for the first few years. However, longer car loans let you secure a more affordable monthly payment, which is likely an important consideration for your budget.

What are Used Car Loan Interest Rates?

Used car interest rates range from 4.08 percent to 20.67 percent for most borrowers, according to the most recent statistics from Experian. Rates for used cars tend to be higher than those offered for new car purchases.

What Credit Score Do you Need to Get 0% financing on a Car?

Superprime borrowers with credit scores above 781 are most likely to qualify for 0 percent APR offers that sometimes come with a new car. However, you may be able to qualify if you’re a prime borrower with a score between 661 and 780.

How do you Get Pre-qualified for an Auto Loan?

You can get prequalified for an auto loan online and without ever leaving your home. All you have to do is select one of the lenders on this list and choose its online option to “get prequalified” or “apply for a loan.” Many lenders let you get prequalified for an auto loan without a hard inquiry on your credit report.

How do I Refinance my Car Loan?

Refinancing a car loan is essentially just taking out a new car loan — so the steps for applying are mostly the same. You’ll need your driver’s license, Social Security number and proof of income, as well as details about your car. If approved, you’ll use the funds from your new loan to pay off your old car loan, then begin making monthly payments with your new interest rate and terms.

Can I Sell my Car with a Loan?

It is possible to sell your car with an outstanding loan, but you may have to go through a few extra steps. If your car is worth less than what you currently owe on the loan, you have what’s known as negative equity — meaning you may need to pay the difference out of pocket or refinance the remaining amount with a different type of loan.

If your car is worth more than what you currently owe, on the other hand, you may be able to pocket the difference in cash when you sell the car. Whatever your situation, reach out to your lender about your options, as each lender sets different rules for selling a car with a loan.

Should I Get an Auto Loan from the Dealership or the Bank?

Choosing between a dealership and a bank for an auto loan is complicated. In general, dealerships may offer higher rates than banks — but this may not be the case for used cars. Regardless, it’s important to get quotes from a few banks or online lenders first; that way you can come to the dealership prepared. Ask for a quote from the dealership as well, comparing rates, terms and any additional fees.

Do I Need to Make a Down Payment or Provide a Trade-in when Buying a Car?

Many lenders require some form of down payment on a car. However, that’s not necessarily a bad thing; making a down payment will lower your monthly payments — and the larger your down payment, the more you save. Making a larger down payment could also lower the interest rate the lender offers you

Obtaining a low APR auto loan rate can save you money over the life of your loan. Before you start shopping for a vehicle, get quotes from several different lenders and compare APRs, loan amounts, repayment terms, credit score requirements, and other terms. Take a close look at the situation so you can choose the loan that will work best for you. Consider looking at credit unions, banks, and nonbank lenders for the best rates.

We hope you will find this information useful. Do you have any queries on how auto loans work? Please feel free to let us know so we can assist you with any information you will need.

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