What Is an Auto Loan? A Comprehensive Guide to Vehicle Financing

Learn how car loans work and how to find the best one for you

Fact checked by Betsy Petrick

What Is an Auto Loan?

An auto loan is a type of secured loan for purchasing a car or other vehicle. The vehicle itself serves as collateral for the loan and can be repossessed by the lender if the borrower defaults. Auto loans today come in many different terms, or lengths, typically ranging from 36 to 72 months, but sometimes up to 96 months.

Key Takeaways

• Auto loans are a common way to buy new or used cars today and are widely available from banks, credit unions, and other sources.
• Your credit score can play a major role in the interest rate you will have to pay.
• Loan rates are also affected by such factors as the size and length of the loan and the value of the car.
• The longer the loan term, the lower your monthly payments may be, but the more you’ll pay in total by the time the loan ends.
• Many lenders will pre-qualify you for a loan. That can be helpful in comparing different loan offers side by side.

How Auto Loans Work

Auto loans work like many other types of loans, with some key differences.

As mentioned above, auto loans are secured, with the vehicle serving as collateral. That contrasts with many personal loans, which are unsecured. Like personal loans, however, your creditworthiness, as demonstrated by your credit score and credit reports, will play a major role in whether a lender will make a car loan to you and, if so, what interest rate it will charge. The better your credit, the better the deal should be.

Some auto loans require no down payment, but experts often recommend making a down payment of 10% to 20% of the car’s value. That will reduce the amount you have to borrow (and eventually pay back) as well as the interest you’ll pay over the course of the loan. Some lenders may also offer you a lower interest rate in return for a higher down payment.

Auto loans are widely available from banks, credit unions, online lenders, and car dealerships.

$47,401

The average cost of a new car in early 2024.

Factors to Consider When Getting an Auto Loan

• Credit score. Your credit score will impact the interest rates that lenders offer. The higher your credit score the more likely you will be to receive loan offers with good interest rates.
• Down payment. While you do not necessarily have to make a down payment to qualify for an auto loan, doing so could lower your interest rate, monthly payments, and total loan cost.
• Terms and conditions. It is important to understand all of the terms and conditions of your loan, including:
• Principal. The principal is the amount of money you’re borrowing. Lenders will use this figure to calculate your interest and fees. In a typical, amortized auto loan, each of your monthly payments will pay off a portion of the principal along with interest.
• APR and interest rate. The terms annual percentage rate (APR) and interest rate are often used interchangeably, but there are some important differences. The interest rate is simply the rate you’re charged on the principle, while APR also includes any other fees and costs associated with the loan. To fairly compare different loans, use their APRs.
• Loan repayment period. Lenders may offer you loans with a variety of repayment periods, typically ranging from 36 to 72 months, although shorter and longer repayment terms are sometimes available. In general, the longer the repayment period, the lower your monthly payments will be, but the more you’ll pay in total over the life of the loan.
• Prepayment penalties. Some lenders charge prepayment penalties if you pay the loan back before the date it would normally have come to an end.
• Other fees and charges. Auto loans can have additional fees, such as an origination fee and a loan processing fee, all of which should be spelled out in the contract.
• Total cost of the loan. This is how much you will have paid for the car when all is said and done, including the down payment, monthly payments, and any fees.

Auto Loan Calculator

You can use an auto loan calculator to determine how your car price, down payment, loan term, and interest rate will impact your monthly payments and overall loan cost.

Types of Auto Loans

You can get an auto loan for a new car or used car. The interest rate for a used car loan is typically higher than one for a new car. For example, the average APR for used car loans was recently 11.6%, compared to an average of 7.1% for new car loans.

Auto loans are also available for refinancing your current car loan or for purchasing a car that is nearing the end of its lease term.

Regardless of why you are exploring auto loans, you can get pre-approved for a car loan to compare your options and choose the best one for you.

Tips for Getting the Best Auto Loan

• Improve your credit score. You can improve your credit by making on-time bill payments, lowering your credit utilization ratio, keeping your oldest accounts open, paying off any delinquent debt, and building out a thin credit file.
• Compare loan offers. Your first loan offer isn’t necessarily the best. You can get pre-approved for multiple loans and compare your options.
• Negotiate terms. You may be able to negotiate your loan’s APR and/or fees, especially if you have strong credit. It is always worth asking lenders for better terms.
• Understand before signing. To avoid unpleasant surprises down the road, make sure you understand all of the loan provisions and fees before you sign the loan agreement.

Alternatives to an Auto Loan

While auto loans are the right choice in many cases, there are alternatives you can consider. It is possible to purchase a car with cash, of course, if you can come up with the money. You can also explore the possibility of buying a car with a personal loan or leasing a vehicle rather than buying one.

Leasing a car involves making monthly payments to a lender in exchange for use of the car for a specific length of time or number of miles. The monthly payments for a lease are typically lower than those for an auto loan, but bear in mind that you don’t accumulate any equity in the vehicle.

What Is the Minimum Credit Score Required to Qualify for an Auto Loan?

While there is no official minimum credit score to qualify for an auto loan, you will likely need a credit score of 661 or higher to obtain a loan with a good interest rate.

Can I Get an Auto Loan With No Down Payment?

You do not need to make a down payment to qualify for many auto loans, but you can expect the interest rate to be higher if you decide to finance the entire purchase.

Are There Any Penalties for Paying Off an Auto Loan Early?

If you pay off your car loan early, your lender may charge a prepayment penalty. These penalties are typically calculated as a percentage of your loan amount.

What Is Gap Insurance?

Gap insurance is a special type of auto insurance that will make up the gap between your car’s value and your loan balance if you owe more than the car is worth. It can be useful in the event of an accident in which your car is totaled.

When Do You Receive the Title for Your Vehicle?

Your lender will hold your car’s title until you have fully paid off your auto loan. After that, the lender will typically mail the vehicle title to you.

The Bottom Line

Given the high prices of cars today, many people need to take out an auto loan to finance the purchase. Before you apply for a loan, consider whether you can afford the monthly payments and how they will affect your overall budget. Be sure to compare loan offers from multiple lenders and don’t hesitate to try to negotiate a better deal.

Read the original article on Investopedia.