A car loan is a type of loan that allows you to borrow money to purchase a new or used car. There are a few different types of car loans to be aware of:
New Car Loan – This type of loan is used to purchase a brand new car directly from a dealership. New car loans tend to have lower interest rates.
Used Car Loan – You can take out a used car loan to finance a used or pre-owned car from a dealer or private party. Used car loans usually have higher interest rates.
Refinanced Car Loan – Refinancing a car loan allows you to potentially get a lower interest rate on your existing auto loan. This involves taking out a new loan to pay off your current one.
Secured Car Loan – The car itself serves as collateral on the loan. The lender can repossess your car if you default on payments.
Unsecured Car Loan – Does not use the car as collateral. Generally have higher interest rates but don’t put your vehicle at risk.
Whether you need a new, used, or refinanced auto loan, understanding the different types is important when shopping for financing. The loan terms, interest rate, monthly payments, and more can vary significantly.
How Car Loans Work
Car loans allow you to finance the purchase of a new or used car. The lender, usually a bank, credit union, or car dealership’s finance department, loans you the money to buy the car. You then make monthly payments on the loan until it’s paid off.
The loan process typically involves:
Getting pre-approved – You can get pre-approved for a car loan before going to a dealership, which shows you what rates/terms you qualify for.
Choosing a car – Select the car you want and negotiate the purchase price.
Final loan approval – The lender does a final review and approves the loan based on your credit, income, and the car.
Signing paperwork – You’ll sign a loan contract agreeing to the loan amount, interest rate, and monthly payment schedule.
Car loans can last anywhere from 12 months to 6 years, with 36-60 months being most common. Shorter loans have higher monthly payments but less interest. Longer loans have lower payments but pay more total interest.
Car Loan Interest Rates
Interest rates are an important factor to consider when taking out a car loan. The interest rate determines how much extra you’ll end up paying above the actual cost of the car over the lifetime of the loan.
Several key factors go into determining your car loan interest rate:
Your credit score – Borrowers with higher credit scores are seen as lower risk by lenders and will qualify for lower interest rates. Those with poor credit will pay higher rates.
New vs used car – New cars can qualify for lower rates since they hold value better. Used cars tend to have higher interest rates.
Down payment – The more you put down as a down payment, the lower your interest rate will be since you’re borrowing less money.
Loan term – Shorter loan terms often have lower interest rates. Going with a longer 6 or 7 year loan will mean a higher rate.
Lender – Banks, credit unions, and dealership financing can offer different rates. Shop around for the best deal.
Special offers – Look for manufacturers’ special financing offers, which can sometimes offer very low rate deals on certain cars.
The best rates are usually under 5% for those with good credit scores applying for a new car. For used cars or poor credit, rates can range from 5-20% or even higher. Checking your credit score, putting more money down, and shopping different lenders can help you land the lowest rate possible for your situation.
New vs Used Car Loans
When it comes to getting a car loan, there are some key differences between financing a new car versus a used car. New cars often come with lower interest rates and better loan terms from lenders compared to used cars. Here’s an overview of how new and used car loans differ:
Interest Rates
New cars tend to get lower interest rates, usually around 2-5%, while used car interest rates are higher, around 4-8% on average. Lenders view new cars as less risky to finance because they have predictable depreciation and no prior wear and tear. Used cars are seen as riskier investments that lose value faster. The newer the used car and lower the mileage, the better interest rate you can expect.
Loan Term Length
New car loan terms are usually 60-72 months, while used car loans are limited to 36-60 month terms. Longer terms mean lower monthly payments, but more interest paid over the life of the loan. With their higher resale value, new cars qualify for longer loan lengths. Lenders want used car loans paid off faster before they depreciate further.
Down Payment
Used cars often require a higher down payment, typically around 10-20% of the purchase price, compared to 0-10% down for new. The higher down payment reduces the risk of the loan being underwater if the used car declines in value.
Credit Score Impact
For new car loans, a FICO score of at least 660 is recommended for approval but used cars often need a score of 720+ for the best rates. Lenders are more lenient on credit for new cars.
Dealer Incentives
New cars tend to come with promotional financing rates from dealers, like 0% APR deals. Used cars rarely have special financing offers. This gives another advantage to new cars.
So in summary, new cars allow buyers to get better interest rates, longer loan terms, lower down payments, and dealer incentives. But used cars are still a smart choice for budget-conscious buyers despite their financing disadvantages. Shop around for the best loan terms on any car purchase.
Improving Your Interest Rate
When taking out a car loan, the interest rate is one of the most important factors as it determines how much you’ll pay over the lifetime of the loan. The higher the interest rate, the more expensive the total cost will be. Here are some tips for getting the best possible interest rate on your auto loan:
Improve your credit score. Lenders offer better rates to borrowers with higher credit scores, as they are seen as less risky. Pay down debts, make payments on time, and limit new credit applications to boost your score. Aim for a score over 700.
Make a larger down payment. Putting more money down upfront shows lenders you are financially stable. Ideally put down 20% or more of the car’s value if possible.
Shorten the loan term. Opt for a 36 or 48 month loan rather than 60 or 72 months. Shorter terms mean less interest paid over the life of the loan.
Provide proof of income. Lenders want to see you can afford the monthly payments. Provide recent pay stubs and tax returns showing your income.
Use an auto loan refinancing calculator. Input your current terms to see available offers with lower rates from other lenders. You may be able to refinance for significant savings.
Consider a cosigner. Adding a cosigner with good credit may help you qualify for better terms. Just be sure the cosigner understands the responsibility they are taking on.
Shop around. Check rates from banks, credit unions, and online lenders. Comparing loan offers will help you find the best rate.
Taking the time to research options and improve your financial profile can help you save hundreds or thousands on interest costs when financing a car purchase.
Dealership Financing vs Banks
Getting a car loan through a dealership or a bank both have their advantages and disadvantages. Here’s a comparison of the key pros and cons of each:
Dealership Financing
Pros
- More convenient – can handle everything at the dealership
- May have promotional financing offers
- Can sometimes get approval faster
- May be more flexible on credit history
Cons
- Rates may be higher
- Limited to that brand’s financing company
- Loan terms not as customizable
- May encourage getting more car than you can afford
Bank Financing
Pros
- Lower interest rates on average
- Can shop rates from multiple banks
- More flexible terms and payment options
- Can get pre-approved before shopping
Cons
- Less convenient – more legwork required
- Approval process can take longer
- May require good credit to qualify
- Fewer promotional financing offers
Overall, bank loans tend to offer lower rates but dealership financing provides simplicity. Consider both options and compare rates and terms to find the best loan for your situation.
Co-Signing a Car Loan
Co-signing a car loan involves having a second person sign the loan agreement and share responsibility for the debt. This is sometimes required by lenders when the primary borrower has little or poor credit history.
When Co-Signing is Required
Lenders will often require a co-signer when the primary borrower:
- Has a limited credit history (e.g. young adults)
- Has a low credit score, usually below 620
- Has past issues like bankruptcies or foreclosures
In these cases, adding a co-signer with better credit can help secure approval or get a lower interest rate on the auto loan.
Risks and Benefits of Co-Signing
The main benefit of co-signing is it allows someone with poor credit to still qualify for a car loan and purchase a vehicle. However, there are risks for the co-signer:
They are equally responsible for repaying the full loan amount. If the primary borrower defaults, the lender can pursue the co-signer for payments owed.
It can negatively impact the co-signer’s credit if payments are missed. Late or missed payments will show up on both individuals’ credit reports.
Co-signing limits the co-signer’s ability to take out more credit until the loan is paid off. Most lenders will view the co-signed loan amount as debt owed by the co-signer.
Overall, co-signing a car loan is a major financial commitment and decision. The co-signer takes on all the liability of the borrower. It should only be done for family members or others with a strong, trustworthy relationship.
Refinancing a Car Loan
Refinancing a car loan involves getting a new loan to pay off your existing auto loan, ideally at a lower interest rate or better terms. This allows you to lower your monthly payments, pay off your loan faster, or both. There are a few key times when refinancing your car loan can make good financial sense:
When Interest Rates Have Dropped
If interest rates have declined since you took out your original car loan, refinancing could allow you to get a lower rate and save money on interest charges over the life of the loan. Track national average interest rates to see if you might qualify for better terms. Generally, you’ll want to look for at least a 2% drop in rates to make refinancing worthwhile after accounting for fees.
When Your Credit Score Has Improved
If your credit score has increased significantly since you got your initial car loan, you may now qualify for a lower interest rate. Even a small boost of 25-50 points in your credit score can potentially lower your rate. Refinancing could help you get better terms. Check your credit report and look for at least a 50 point improvement to make refinancing a viable option.
When You Want to Shorten Your Loan Term
Refinancing gives you a chance to shorten the length of your car loan, which can help you save on interest charges and pay off your principal faster. Crunching the numbers to see if refinancing to a 24, 36 or 48 month loan makes sense could reveal sizable interest savings.
How to Refinance Your Car Loan
The process of refinancing involves applying for a new car loan through your bank, credit union or online lender. Have details on the make/model of your car, mileage, and your loan balance amount ready. Shop around with multiple lenders to compare interest rates. Once approved, you’ll use the new loan to pay off the old one and continue making monthly payments at your new lower rate. Be sure to compare closing costs vs. interest savings.
Defaulting on a Car Loan
Defaulting on a car loan occurs when you fail to make your monthly payments as outlined in the loan agreement. This has serious consequences that can significantly damage your finances and credit score.
When you default on a car loan, the lender has the legal right to repossess your vehicle and sell it in order to recoup their losses. They will send you a written repossession warning first, but if you cannot become current on the loan, they can take back the car. Many lenders will work with borrowers to try to modify payments before repossessing, so communicate with them if you anticipate not being able to make payments.
In most states, the lender has to sell the repossessed car in a “commercially reasonable” manner, but you will still owe the difference between what the car sells for and what you owed on the loan. This remaining balance is called a deficiency and you are still responsible for paying it. The lender can take legal action, like filing a lawsuit or garnishing wages, to collect this amount.
A car loan default will also severely hurt your credit score, making it difficult to qualify for future loans or lines of credit. The late payments will show up on your credit report and the default can stay on your record for up to 7 years. Your credit score could drop by over 100 points.
To avoid defaulting, be realistic about what you can afford when taking out a car loan. Build an emergency fund that could help you make payments if you lose your job. Refinance the loan if possible to lower payments. Communicate openly with the lender at the first sign of financial hardship to modify the loan terms. Defaulting should only be a last resort, as the consequences can be financially devastating.
Alternatives to Car Loans
Taking out a car loan is one of the most common ways that people finance a new or used car purchase. However, there are some alternatives to consider if you want to avoid taking on debt or paying interest:
Buy Outright
The most straightforward alternative is to pay for the car entirely in cash upfront. This avoids financing charges but requires you to have a large amount of savings on hand. Setting aside money each month into a dedicated car fund can make buying outright more feasible. Downsides are tying up money that could otherwise invest and lack of budget flexibility if the full amount isn’t saved yet.
Lease the Car
Leasing a car involves paying only for its depreciation during the lease term, usually 2-3 years, plus fees. Monthly payments are generally lower compared to financing the same car. You won’t own the car after the lease and will need to return it unless you buy it out. Mileage limits usually apply. Leasing works best for those who like driving new cars and can deduct payments as a business expense.
Borrow from Friends/Family
Asking friends or family for a personal loan to buy a car is another option. This avoids traditional financing but make sure to formalize loan terms and plan for repayment. Be cautious borrowing from someone you have an ongoing relationship with in case issues come up with making payments.
Use Public Transportation
Relying on public transportation like buses and trains instead of owning a car eliminates the purchase price and ongoing costs like fuel, insurance and maintenance. This works best if you live in an area with robust transit infrastructure. Downsides are lack of flexibility and limited cargo space.
So in summary, car loans provide a straightforward financing method but also consider paying cash, leasing, borrowing from others or using public transit depending on your financial situation and transportation needs.