What You Need to Know About Car Loans

Find out how to save when you're shopping for a car loan

If you need a car, but you don't have enough money to buy one outright, you're not alone—most Americans don't have enough cash on hand to buy even a quality used car, much less a new one. Many of us need a vehicle to meet our day-to-day responsibilities, though. A car loan can help get you on the road.

The world of car loans can be overwhelming, so it's best to start with the basics. Understanding how a car loan works is the first step in getting a good deal.

What Is a Car Loan?

A car loan is a personal loan that you use to purchase a vehicle. More specifically, a lender loans the borrower (you) the cash it takes to buy a vehicle. In return, you agree to pay back the lender the amount of the loan plus interest, usually in monthly payments, until the amount owed is fully paid off.

Many personal loans are unsecured loans. That is, the loan is made based on the borrower's creditworthiness, and not secured by some form of collateral. Collateral is property or assets that the lender could take back and sell if you don't repay the loan.

Car loans are different in that they are almost always secured loans, and the collateral is the vehicle itself. That means that if you fail to make your payments, your vehicle could be repossessed and sold to pay off the loan debt.

You probably already have at least one unsecured loan (and possibly several). Most credit cards are unsecured loans.

The Building Blocks of a Car Loan

A car loan (and most loans in general) consists of four factors that you should consider before you sign on the dotted line: loan costs, interest rate, down payment, and terms.

Loan Costs

There are two basic parts to the cost of a car loan: the principal and the interest. The principal is the negotiated cost of the vehicle itself. The interest refers to the costs accrued over the life of the loan based on the principal amount and the stated interest rate.

Your loan costs may also include fees. Some of these fees, like taxes and title costs, are non-negotiable. Some fees, like delivery charges and origination fees, are negotiable.

Interest Rate

An interest rate is a basic rate charged to the borrower for the money loaned. Your car loan may show two rates: your annual percentage rate (APR) and your interest rate. The APR includes fees associated with the loan. When you're loan shopping, make sure to compare APR to APR and interest rate to interest rate so you're comparing apples to apples.

Down Payment

The down payment is an upfront payment you make at the time of the purchase of the vehicle. You can also use a trade-in vehicle as a down payment. Your down payment is usually expressed in terms of a percentage of the total price. The larger your down payment is, the less you need to borrow.

Terms and Conditions

These are all of the other items that make up a car loan, including the loan term, normally stated in a number of months or years; insurance and registration requirements; loan payoff and resale terms; maintenance requirements; conditions regarding theft or accidents; and conditions of loan default and repossession. There may be other conditions as well, and it's important to read them over carefully and have a clear understanding of what they mean before signing on.

The Car Loan Process

Follow these five steps to help your car loan process go smoothly.

  1. Determine what you can afford: Get out a piece of paper and work out a realistic budget that tells you what you can afford in terms of a monthly payment. Keep ongoing costs in mind too, including insurance, maintenance, and gas. Next, determine the amount of the down payment you plan to make or the value of the vehicle you're planning to trade in.
  2. Check your credit score: It's helpful to know where you stand in regard to your credit score before talking to lenders. Some websites offer access to free credit scores. You can also pay to get your scores directly from credit bureaus. Lenders rely on credit reports and scores when determining loan interest rates and terms. The higher your credit score, the better position you will be in to lock in a lower rate.
  3. Shop around for the best loan terms: Rates and terms vary, sometimes considerably, between lenders. Contact multiple lenders to get a quote, including your bank or local credit union. Your dealer may also offer financing, but if you look for the best loan deal before heading out to shop for a car, you're in a better position to negotiate.
  4. Get pre-approved: Getting pre-approved for your loan means that you've set your limits before setting foot in a dealer's showroom. Getting pre-approved doesn't mean you've made a commitment, but it does give you an idea of what you can afford.
  5. Shop for your car: Now it's time to visit your local auto dealers. Find the exact car you want, and then let your lender know the year, make, model, and Vehicle Identification Number. You will also need to purchase car insurance as soon as possible. Most dealers will not let you drive away without showing proof of car insurance.

Improving Your Chances of Getting Approved for a Car Loan

What if your credit isn't good enough to get a car loan on your own? Here are a couple of ways to improve your odds.

Get a Co-Signer

Is your credit score too low (or nonexistent) to qualify for a decent car loan? A co-signer can change all of that. A co-signer puts their name and credit score on the line for your purchase. If you don't pay, their credit will be affected just as if the loan were solely in their name. Typically a co-signer is a very close relative such as a parent. It's a good way for you to establish credit and build a great credit score.

Stay away from "conditional" or "contingent" loans in which you sign a loan agreement with a dealer and drive away with your new car before all of the terms of the loan have been finalized. Important items such as interest rate, loan period, down payment, and the amount of the monthly payment may be changed (almost certainly to your disadvantage). You could be stuck paying a lot more than you intended.

Peer-to-Peer Auto Loan

Can't find a co-signer to back you? Peer-to-peer auto loan websites are available to help connect lenders and buyers. With peer-to-peer lending, instead of applying for a loan from a large corporation, you're seeking a loan from individual investors. After setting up a profile explaining why you need the loan, your credit score will be run, and you will be slated "high risk" if you have a low or nonexistent score.

Individuals will review your profile and decide whether or not to fund the loan. If there's enough interest, your loan will be funded and you can use the proceeds to buy a car. You repay the loan through the peer-to-peer platform and the investors benefit from the interest you pay.

The riskier the loan is for investors, the higher the interest rate. It's another lending source worth considering whether your credit is good or bad.

Article Sources

  1. GoBankingRates. "Survey: 69% of Americans Have Less Than $1,000 in Savings." Accessed May 13, 2020.

  2. Federal Trade Commission. "Financing or Leasing a Car." Accessed May 13, 2020.

  3. MyCreditUnion.gov. "Personal Loans: Secured vs. Unsecured." Accessed May 13, 2020.

  4. Small Business Administration. "Collateral and Credit." Accessed May 13, 2020.

  5. Consumer Financial Protection Bureau. "Auto Loans Key Terms." Accessed May 13, 2020.

  6. Consumer Financial Protection Bureau. "Comparing Auto Loans." Accessed May 13, 2020.

  7. Consumer Financial Protection Bureau. "Plan to Shop for Your Auto Loan." Accessed May 13, 2020.

  8. Consumer Financial Protection Bureau. "Where Can I Get My Credit Score?" Accessed May 13, 2020.

  9. The North American Securities Administrators Association. "Peer-to-Peer Lending." Accessed May 13, 2020.