Understanding the Different Types of Auto Loans

If you’re financing a car, you could have several kinds of loans to choose from. Here is how to find the best one for you

Fact checked by Betsy Petrick

If you are planning to take out an auto loan to finance the purchase of a car, you could have several different types to choose from. For example, auto loans can be secured or unsecured and direct or indirect. The interest that they charge can be calculated in different ways. You might also want to consider specialized auto loans. Understanding the ins and outs of the various kinds of auto loans can help you find the best one for you.

Key Takeaways

• Secured auto loans, the most common type, use the car as collateral.
• Unsecured auto loans are not tied to collateral, but they may have higher interest rates and fees.
• Direct financing from a bank or other lender and dealer-arranged financing are two common options for auto loans.
• The interest on auto loans can be calculated in different ways, including simple interest and precomputed interest.

Secured vs. Unsecured Auto Loans

What is the difference between secured and unsecured loans? A secured loan is backed by collateral. In the case of a secured auto loan, you car serves as collateral. If you are unable to make payments on the loan, the lender can repossess the car and sell it.

Unsecured loans are offered based on your creditworthiness and not tied to any collateral.

Secured loans typically have lower interest rates and fees than unsecured loans because lenders are taking less of a risk. You may also be able to borrow more money and repay it over a longer period with a secured loan.

While secured loans have advantages, an unsecured auto loan may be the right choice in some cases. Some people prefer the peace of mind of knowing that their vehicle cannot be repossessed if they have an unsecured loan.

Simple Interest Auto Loans vs. Precomputed Interest Auto Loans

Simple interest loans are much more common than precomputed interest loans, although you may encounter both kinds when you go auto loan shopping. If you opt for a simple interest loan, your interest will be calculated using the outstanding balance of your loan at any given time, much like a home mortgage or other amortized loan. At the outset, your monthly payments will go largely toward interest, but the portion of your payment that is applied to principal will rise over time.

Precomputed interest, on the other hand, is calculated upfront and spread evenly over your monthly payments.

If you plan to make extra payments or think you might pay off your loan early, a simple interest loan will be the better choice. Those extra payments will reduce your principal and the overall amount you owe. Extra payments on a precomputed interest auto loan do not reduce the principal or interest you owe.

Tip

An auto loan calculator can give you an idea of what your monthly payments and total interest costs could look like with different loans.

Direct Auto Financing vs. Indirect Auto Financing

Direct auto financing involves applying for a loan with a lender like a bank or credit union. Indirect auto financing involves working with a car dealership. Typically, the dealership will originate the loan and then sell it to a third party.

Direct auto financing can give you some flexibility. You can get prequalified with multiple lenders before or after you have found the car you want to purchase. Direct financing may also be less expensive.

Indirect auto financing can be quick and convenient, since you won’t have to shop around with lenders. Instead, the dealership will present you with one or more offers. But keep in mind that you might do better elsewhere.

Securing direct financing prior to visiting a car dealership can prepare you to compare offers and settle on the best option, whether it’s direct or indirect.

Warning

While not a car loan like the ones discussed in this article, another type of auto-related loan is a title loan. Drivers who own their cars outright can apply for one of these very short-term loans, using the car as collateral. Typically promoted to people with poor credit and a need for quick cash, these loans can have extremely high interest rates and are often called predatory.

Specialized Auto Loans

There are also some other types of auto loans for borrowers in certain situations.

Military service members. If you currently serve in the military or are a veteran, many lenders offers loans with special discounts and benefits. But it’s still worth comparing these offers to others that might be available to anyone, particularly if you have strong credit.

Borrowers with poor credit. Special financing, as it’s known in the auto lending industry, can help borrowers with poor credit or a limited credit history obtain loans. Car dealerships may advertise special financing to attract customers who wouldn’t qualify for regular auto loans. Bear in mind that these loans usually come with higher interest rates, which may make it more difficult to afford the monthly payments. In the worst case, that could lead to the repossession of the vehicle.

What Is the Difference Between Prequalification and Pre-Approval for an Auto Loan?

The terms “prequalification” and “pre-approval” can mean different things depending on the lender. Some lenders may offer you a prequalification letter, based on unverified information about your finances, and then offer a pre-approval letter based on verified information.

Regardless of how the term is used, a prequalification or pre-approval letter shows you how much a lender may be willing to lend you. But these letters are not guaranteed offers.

What Is the Average Length of a Car Loan?

The average length of a car loan today is about 72 months.

What Credit Score Do I Need to Get an Auto Loan?

While there is no set minimum credit score for an auto loan, most lenders will want to see a score of 661 or higher in order to offer a conventional loan. Some lenders will have lower thresholds, but they are also likely to charge more.

What’s the Average Interest Rate on an Auto Loan?

Interest rates are typically higher on loans for used cars than new ones. In early 2024, the average APR on used cars was 11.6%, compared with 7.1% on new cars.

How Much Money Can I Get With a Title Loan?

According the the Federal Trade Commission (FTC), title loans usually range from 25% to 50% of the car’s value. The FTC also points out that title loans are expensive “and they can trap you in debt.”

The Bottom Line

When financing a car, you can have several types of auto loans to consider. Compare secured and unsecured loans, simple interest and precomputed interest loans, direct and indirect financing, and specialized loan options to determine the best car loan for you.

Read the original article on Investopedia.