A car loan or auto loan is funds borrowed in order to purchase a motor vehicle. The loan is offered by a dealer or a financial institution and enables the client to pay the dealer or the manufacturer of the car.
The loan could be secured by the value of the vehicle being purchased which means that the vehicle acts as collateral. The borrower does not technically own the car until the loan is fully paid off. If the borrower is unable to pay back the loan, the vehicle is repossessed and sold in order to recoup the losses. A secured loan such as an auto loan is less risky and so offered at a relatively lower interest rate than an equivalent unsecured loan such as a personal installment loan.
The loan could also be unsecured where the lender relies more upon the promise that the borrower will repay the debt. Unsecured loans are not common and are usually given at higher rates.
Auto loan differs with a title loan because an auto loan is taken out to purchase a car whereas a title loan is taken out against a car that the borrower already owns.
Factors to consider before applying for an auto loan
- Loan tenure – A majority of lenders offer loan tenure of up to 7 years. However, it’s prudent to opt for a shorter duration as it will reduce your interest cost.
- Loan Amount – Many financiers have an option to finance the full amount of the vehicles cost. But it is always advisable to reduce your interest cost by opting for a lower amount which can be obtained by paying a down payment.
- Processing fee – Different lenders charge different processing fees to cover the cost they incur during the loan application process. The fee is usually non-refundable. The fees may be waived off during certain seasons and through some offers. Always read the fine print to compare the fees charged by different lenders and ensure that the fees charged are not compensated through other avenues like charging higher interest rate or other hidden charges to offset the losses incurred in waiving off the processing fees.
- Prepayment charges – Car loans take on a fixed interest rate which usually comes with prepayment and foreclosure penalty charges that can be as high as six percent of the total outstanding loan. Some lenders also cap the size and number of prepayment allowed during a year or during the loan tenure. Always consider lenders prepayment charges and other prepayment limitations before taking out a loan.
- Credit score and report and loan rates – An auto loan is secured but a lender would still consider the borrower’s creditworthiness when taking out an auto loan. Some lenders fix loan rates and approve loans depending on the credit score of the borrower.
An auto loan offered to people with bad credit ratings is called a subprime auto loan. The subprime auto loans incur higher interest rates than a standard auto loan due to their increased risk of lending to the borrowers with poor credit. A subprime loan sometimes also comes with prepayment penalties for borrowers who pay off the loan earlier than agreed. Check your credit score before applying for a loan and if it’s low, find out how to improve it.
Auto Loan Types
There are three major options for financing a car which includes direct lending and dealership financing.
- Direct Lending involves a person getting a vehicle that they wanted to buy and then visits a bank, a credit union or any other financial institution for funding. Then the person works with the lender to obtain a loan for the amount required paying for the purchase of the motor vehicle. The car serves as the collateral and the lender owns the car until the borrower settles the loan. This option is slower but has lower interests and there are two parties involved.
- Dealership Financing occurs when the borrower gets an auto loan through the auto dealer that is selling the car. In a dealership process, there are other different lenders involved which means, they are able to get several lenders and then choose the most favorable one. This option is easier and faster as the borrower only deals with the auto dealer directly and is not required to leave the dealership in order to get a loan. However, this option is more expensive because the dealership would be making a profit from the auto loan which results in higher interest rates for the borrower.
- Loan Connecting Service is similar to dealership financing. Instead of borrowers apply through the dealership, they would fill an application online through a free service who will connect the borrowers to several lenders from one application. This way usually would help the borrower to achieve a better rate even though he/she has a bad credit. The downside of this method is your information is shared among several lenders, which sometimes you may receive some unwanted phone calls or emails.
Another type of car loan is the finance lease where the financier purchases the motor vehicle and leases it to the motorists. There is also an operating lease. This involves entering into an agreement where the financier purchases the vehicle and rents it to the motorists but retains ownership of the vehicle. Another type of car loan is the novated lease. This involves creating a three-way arrangement where the employee agrees to have their wage reduced in exchange for an equal value of car benefits.
How an Auto Loan is structured
An auto loan is structured as installment meaning the loan is paid off in a series of regular payments which are usually monthly payments. The term of a typical auto loan is usually around 3 to 6 years. The longer the loan payback term, the greater the amount of interest incurred and the more the loan costs overall. However, a loan that has longer terms also have lower monthly payments.
The principal amount of an auto loan is determined by the value of the car. The down payment required depends on the vehicle or the dealership. The greater the down payment, the lower the principal amount which means reduced risk for the lender and lower costs for the borrower. For example, If the value of the vehicle s $50,000, the principal amount is $50,000 but if the borrower pays a down payment of $10,000 then the amount of the auto loan reduce to $40,000.
The loan interest is the amount the lender charges on top of the lent amount of auto loan. This is basically the cost of the loan or the amount the borrower pays in order to cater for the privilege of borrowing money. Interest is a percentage of the principal amount over a certain period of time. An auto loans simple rate is different from the Annual percentage rate (APR). If an auto loan had a yearly interest rate of 5%, then the loan would accrue $2,500 in interest over the period of one year. The APR represents the true cost of the loan.
An auto loan is a good way to purchase a car but you have to weigh the benefits versus the costs and ensure that you have planned on how the debt will be repaid.