Everything to Know About a Car Loan
You want to make sure you take your time, find the best terms, and you’re prepared before you apply for a vehicle loan.
21:10 13 December 2021
If you’re ready to sell your current car and buy a new one, you may be financing it. Getting a car loan can be one of the bigger financial decisions you make, second perhaps only to a mortgage. You want to make sure you take your time, find the best terms, and you’re prepared before you apply for a vehicle loan.
The following is a guide to everything you need to know.
What is a Car Loan?
Most people can’t afford to buy a new vehicle in cash. As a result, you may need a loan to cover at least part of the cost.
When you sign a car loan, you’re making an agreement with a lender. The lender is giving you the money to buy a car. You pay them back with interest in a time frame you both agree upon.
So often, people will spend all of their time figuring out the type of vehicle they want. Then they wait until they visit a dealership to think about financing. It should be the other way around because figuring out your financing is just as important, if not more so than the car you choose.
When you get a car loan, the lender holds the title to the vehicle until you pay it off. When you pay it off, then you truly own the car.
Types of Car Loans
There are some different types of auto loans which include:
1. Secured: A secured car loanis guaranteed by a lien on the underlying asset. In this case, the underlying asset is the vehicle. If you don’t meet your obligation on the payments, the lender might be able to repossess your vehicle. After you pay it off, the lender no longer has that right. Secured loans aren’t as risky for a lender, so you may be able to get a lower interest rate.
2. Unsecured: It’s not common that a car loan would be unsecured. However, if it was, a lender couldn’t repossess your vehicle if you didn’t make the payments. Your interest rate would be higher in almost all cases since the lender is taking on more risk.
3. Simple interest loans: A simple interest loan is one where your balance accrues interest periodically. This might be daily, for example. You make monthly payments, but you can speed up your payoff and limit your interest costs by making additional principal payments. A simple interest loan offers more flexibility to borrowers, and if you have a lot of personal savings, you might choose this option.
4. Pre-computed: A pre-computed car loan has less flexibility than a simple interest loan. You make payments on a scheduled basis, and each payment is a share of the principal and interest. You’re front-loading the payoff with this type.
5. Title loans: This is a secured loan that you can use to borrow against the value of your car, so it’s not the same as the other financing options.
6. Lease buyout: With a lease buyout loan, you have a path to owning a vehicle after leasing it. The lender pays a lease buyout fee upfront, and then if you’re the borrower, you make fixed payments over a certain term. Then, once your principal is paid off, the lien is lifted by the lender, and you own the vehicle.
You can buy a new or used car with no money down, although it’s not the best financial decision. You could end up paying a lot in interest if you put no money down.
The down payment is the amount you can put toward purchasing a new vehicle in cash. The higher your down payment, the smaller your loan amount will be. You can lower your monthly loan payment by putting up as much for a down payment as you’re comfortable with.
The interest rate on your car loan is the percentage of the principal your lender charges you on the money you borrow. The principal is the total amount you borrow. The interest you pay is how a lender makes money.
Lenders calculate interest rates based on factors like your credit history and score, your down payment, and your loan term. The type of vehicle can also play a role in your interest rate.
With simple interest, the calculation is based on the amount you owe when your car loan payment is due. You could decrease the interest you owe if you pay more than the amount due every month. Precomputed interest is calculated ahead of time, so you’re not going to decrease what you pay in interest even if you make a larger payment.
The terms of a car loan are how long you’ll have to pay back the money you borrow to the lender. Car loan terms generally vary from three to six years but can be both shorter and longer.
Loan terms are a number of months. For example, your loan terms might be 36 or 60 months.
The shorter your loan term, the higher your payments. However, when you extend your terms, you pay more in interest over the long term.
When borrowers have longer loans, it’s more risk for the lender. A lender will give you more favorable terms if you have a shorter term.
Generally, if you’re going to get a car loan, the process can look like the following:
1. Figure out what you can afford. Create a budget before you do anything else. You want to figure out your budget based not on the cost of the vehicle but on what you can afford to pay every month. You also need to consider expenses like maintenance and gas and factor those into your budget planning.
2. Determine the amount of the down payment you’re going to make or the value of your trade-in.
3. Check your credit score. You should know where you stand and make sure there aren’t any errors on your credit report.
4. Shop around and compare loan terms. There can be pretty significant variance in loan terms and rates between lenders. Get multiple quotes. Compare your options from local banks or lending institutions and online banks. You might also talk to a dealer about their available financing options.
5. Get a pre-approval. When you have a pre-approval for a loan, you’re setting limits and boundaries for yourself before you ever start shopping. You’re not committing to anything with a pre-approval, but it lets you know what you can afford.
6. Have car insurance. Most dealers won’t let you leave with a vehicle if you don’t have proof of insurance.
The 14-Day Window
When lenders check your credit score, it will cause it to go down slightly. To combat this, try to manage your car loan application process within two weeks.
There’s something dubbed a shopping period. The shopping period is 14 days, so any inquiries made during that period are all considered one, reducing the impact on your score.
Financing from a dealer can seem appealing at first. For example, the dealership might be advertising 0% financing and cash-back rebates. However, these offers are only available to the most high-qualified borrowers. If you don’t have excellent credit, you may not qualify.
Even if you do have excellent credit, you should always shop around and avoid accepting the first financing option you come across.
What Credit Score Do You Need?
Finally, every lender and situation is different, so there’s no way to say specifically what credit score you need to buy a car.
We do know in the second quarter of 2020, people who got loans for new cars had average credit scores of 718. People who got loans for used cars had scores of 657, based on findings from the 2020 Experian State of the Automotive Finance Report.
If you have a good credit score, you’re considered prime or super-prime, meaning you’ll get a lower-than-average interest rate on your loan. If you have a poor score, it’s called deep subprime, so if you are approved, you’re very likely going to pay a higher interest rate.
Before you shop for a car, along with checking your credit score, it’s a good idea to work on improving it if needed.
You should make sure there are no errors. Think about paying off any debt or at least reducing it before you start shopping.
Saving for a bigger down payment can help you get a lower rate too. When you pay more upfront, a lender will see you as a lower risk.
A co-signer with a higher credit score than you can help you get approved and possibly secure a lower interest rate.
A co-signer puts their name and credit score on your application. If you don’t pay your loan, the co-signers credit is affected as if the loan was their own and only in their name.
The factors that make up your credit score include your payment history and credit utilization, as well as the age of your accounts, your account mix, and inquiries.