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Cars are expensive, which is why many people rely on car loans to finance them. Taking out a loan is a big decision, so it’s important to understand how car loans work before applying.
What is a car loan?
A car loan is a type of installment loan used to purchase a vehicle. This is a legally binding agreement between you and the lender which states that they will give you the funds to buy a car and in return you will repay the full amount of the loan plus interest on a specific date .
How do auto loans work?
A car loan can help make buying a vehicle more affordable by dividing the cost into monthly payments over a period of time. Auto loans typically range from a few thousand dollars to $100,000 or more. They usually come with repayment terms of 24 to 84 months, depending on the lender. The amount you can borrow will depend on the vehicle and your financial situation.
The payments you make on a car loan will go toward your principal loan amount plus the interest charged by the lender. Your overall interest charges will depend on the interest rate to which you are entitled. In general, the higher your credit score, the better your rate will be. Many lenders also offer lower rates to borrowers who opt for shorter repayment terms.
Note that while you are paying off your car loan, the lender will be a lien holder on your car, which means they can repossess the vehicle if you fail to make your payments. During this repayment period, most lenders will also retain title to your car. If you repay the loan successfully, the lender will be removed as a lien holder and will then release the title to you.
Auto loan conditions to know
There are several common terms you’ll likely come across when shopping for a car loan, including:
Interest on a loan is basically what a lender charges in exchange for granting loans. Your interest rate illustrates the amount you can expect to pay in interest, expressed as a percentage. The lower your rate, the less interest you will have to pay.
To qualify for a good interest rate, you will generally need good to excellent credit. Many lenders also offer lower rates to borrowers who opt for shorter repayment terms.
Annual percentage rate
The Annual Percentage Rate (APR) includes both the interest and the fees you will pay on the loan. The higher the APR, the higher the overall cost of your loan will be.
When weighing your options with different auto lenders, be sure to compare their APRs — not just their interest rates — to better understand how they stack up on price.
This is the amount you will pay for a vehicle upfront and could be cash, what is offered to you for trade in or a combination of both. You can then take out a car loan to finance the remainder.
Many auto lenders require a down payment of at least 10% of the purchase price of the car. Generally, it’s a good idea to put at least 20% for a new car and at least 10% for a used car. Although some lenders offer no down payment loans, keep in mind that the more you are able to set aside, the less you will have to borrow and the less interest you will be charged.
This is the amount of money you borrow and agree to repay to the lender. Note that this does not include interest, fees, penalties or other costs.
This is the amount you have to pay each month for an auto loan. Part of your monthly payment will go towards your principal while the rest will be applied to interest.
The split of your payment between principal and interest depends on whether your loan is charged:
- simple interest: Based on your loan balance on your payment due date
- Pre-calculated interest: Calculated when you take out the loan and is based on the amount you borrow
term of the loan
The duration of your loan (or repayment term) corresponds to the time allotted to you to repay your loan. Auto loan terms typically range from 24 to 84 months, depending on the lender.
It’s usually best to choose the shortest term you can afford to keep your interest charges as low as possible. Remember that many lenders offer better rates on short term loans.
Also, while this often means your repayment period, keep in mind that the phrase “loan terms” can also refer to your loan details, such as your monthly payment, interest rate, and term. due date.
If you’re having trouble getting approved for a car loan, applying with a co-signer could increase your chances of approval. This is someone with good credit, such as a parent, other relative or trusted friend, who is willing to share the responsibility for your car loan.
In addition to making it easier to qualify for a loan, having a co-signer could also help you get a lower interest rate than you would get on your own. Just keep in mind that if you can’t keep up with your payments, they’ll be on the hook.
This is the total amount of your loan, i.e. the amount you will actually pay for your vehicle during the term of the loan. It includes both principal and interest.
How to qualify for a car loan
To be approved for a car loan, you will usually need:
Lenders will review your credit to determine your creditworthiness. Most require good to excellent credit to be approved – a good credit score is generally considered to be 670 or higher. There are also several lenders who offer loans to borrowers with bad credit, but these usually come with higher interest rates than loans with good credit.
For this reason, it’s a good idea to check your credit before applying so you can see where you stand. You can use a site like AnnualCreditReport.com to view your credit reports for free. If you find any errors, dispute them with the appropriate credit bureau to potentially increase your credit score.
You will need to prove that you can afford to repay the loan. To do this, you will usually need to provide information about your financial situation, starting with your income. So be prepared to provide pay stubs or a copy of your tax return.
Low debt to income ratio
Your debt-to-income ratio (DTI) is the amount you owe on monthly debt payments relative to your income. To get approved for an auto loan, your DTI ratio must not exceed 50%, although some lenders require ratios lower than this.
Where to get a car loan
If you’ve never purchased a vehicle on a loan before, it’s natural to assume that the dealership takes care of everything from supplying inventory to lending the money. But while many dealerships offer financing, you also have other options to consider.
These are lenders who work directly with borrowers, such as online lenders as well as traditional banks and credit unions. If you are approved by a direct lender, you will receive a check to give to the dealership.
Since these lenders compete for your business, they give you more opportunity to shop around and compare your options, which can help you find a good deal. Many offer pre-approval, which lets you see your personalized rates after providing some basic information and agreeing to a soft credit check that won’t impact your credit.
Keep in mind that if you already have an account with a bank or credit union, you may qualify for rate reductions if you also take out an auto loan with them.
Internal dealer financing
This type of financing is offered by dealerships directly to borrowers, sometimes through the dealership itself or through lenders it has partnered with. If you have bad credit, you may find it easier to qualify for in-house financing than to get a car loan from a direct lender.
But the downside of these less stringent requirements is often a higher interest rate. So while financing a car through a dealership can be attractive since you can do it all at once, it’s still worth shopping around to see if you can find a better deal elsewhere.
Note that dealerships sometimes offer special 0% APR deals or other incentives, such as bonuses or cash back. Qualifying for one of these might be worth taking on an in-house loan, but make sure you understand the terms and requirements before signing on the dotted line.