In an ideal world, most of us would pay for a car upfront in cash. In reality, most of us can’t afford to do so. Auto loans offer the opportunity to finance the purchase of a new vehicle over time. A good auto loan provides financial flexibility, helps avoid debt traps, and contributes to stable, worry-free finances. That said, it is important that you fully understand the auto loan process to ensure you are making informed decisions. Keep reading as we guide you through the world of auto loans.
What Is an Auto Loan?
In short, an auto loan is a loan given by a financial institution with the specific purpose of buying a car. The lender pays the car dealer up front, while the borrower pays the lender the full loan amount plus interest and fees over an agreed period of time.
In general, the auto loan process includes a loan application to a bank or dealership, which will typically request things like employment details and the amount you wish to borrow. A lender will perform a credit check to determine whether to approve your application and decide on what interest rate to offer.
The term of an auto loan is usually between 36 and 72 months, with longer terms meaning lower monthly payments but more interest paid throughout the period. Most auto loans will require the borrower to make a down payment of the vehicle’s original purchase price. This is typically between 10% and 20% of the car’s original purchase price.
Types of Auto Loans
There are many different types of auto loans available on the market, so it is important to understand the different car financing options available. Most loans are either secured or unsecured.
A secured auto loan uses an asset - which is usually the vehicle being purchased - as collateral to reduce the risk to the lender. They often offer better interest rates than unsecured auto loans. However, they also enable the lender to repossess the car if you default on your repayments.
On the other hand, unsecured auto loans are personal loans used to purchase a car. The interest rates are often higher than secured auto loans and require a solid credit score as no collateral is required.
Auto loans are usually available from banks, online dealers or credit unions, although dealership financing is also an option. While the auto loan process is most seamless when done through a dealership, it leaves little choice in the ability to choose a lender as the dealer will pair the lender and the borrower together.
Once you have an auto loan, there is the possibility of refinancing. Auto loan refinancing allows you to swap your current auto loan for a new one. Refinancing can allow you to extend your auto loan term to a lower monthly payment or reduce the term to pay it off faster. Refinancing your auto loan can result in a more affordable rate if market rates have dropped since you took out your original loan. If your credit score has improved over time, refinancing your auto loan may also qualify you for a better deal.
Preparing to Apply for an Auto Loan
Check Your Credit Score
A strong credit score is essential for securing good auto loan terms. A good credit score will help the lender assess your financial reliability and risk as a borrower. Your credit score provides insight into your repayment habits, ability to manage debt and financial history. If you have a high credit score you will have an increased chance of loan approval, as well as access to lower interest rates and more flexible payment options. Conversely, a low credit score may result in stricter terms, higher interest rates and in the worst-case scenario, loan denial.
There are three credit bureaus in the US where you can check your credit score: Experian, Transunion or Equifax. Checking your credit score and credit report is free, but you will need to create an account.
If you think you need to improve your credit score, you can do this over time by making payments on time, reducing your debts and keeping credit utilization low. Improving your credit score will take time but will ultimately enable you to secure more favorable auto loan terms.
Set a Budget
It is important to calculate a realistic budget for monthly payments to ensure the loan comfortably fits within your budget. Consider the following:
Net income: What you take home after taxes, benefits and other deductions
Fixed monthly expenses: Utilities, insurance, loan payments, rent or mortgage etc.
Variable expenses: Groceries, subscriptions etc.
Debt payments: Credit card bills, student or personal loans
It is advisable to use the 15% rule for auto loan payments, so your monthly payment should be no more than 15% of your monthly take-home pay. For example, if you bring home $2,000 per month, your total auto loan payment should be no more than $300. This will mean you are not overextending yourself.
Understand Loan Terms
When researching auto loan options, you are likely to come across the following terms:
APR: Annual Percentage Rate. This is the interest rate you will be charged on the loan over a year, which is charged as a percentage rate. It includes the interest rate as well as any additional costs associated with the loan.
Principal: The amount of money you are borrowing from the lender, excluding interest or fees.
Loan term: The length of time over which you agree to repay the loan.
Monthly payment: This is the payment you will pay off each month to pay off your auto loan. This includes interest and any fees.
Prepayment penalty: A fee that may be charged if you pay off your loan early to compensate the lender for any lost interest.
Lien: The legal claim the lender has on the car until the auto loan is fully paid off.
Default: Failure to make the required payments on the auto loan.
Tips for Securing a Favorable Loan
Save for a Down Payment
A larger down payment will result in lower interest rates. It is recommended that at least a 20% down payment be paid, although lower down payments are now becoming more common. In general, it is agreed that the higher the down payment, the less you will need to borrow and the less interest you’ll be required to pay.
Get Pre-Approved
Getting pre-approved for an auto loan will ensure you know you are able to afford the monthly payments before shopping for a car. Here we break down how to get pre-approved for an auto loan:
Gather your documents: Lenders are likely to require the same information from you, including your name, address, occupation, income and social security number. You should be prepared to have your tax returns, pay stubs, bank statements and ID.
Collect pre-approval offers: It’s a good idea to shop around and not settle for the first auto loan that accepts you.
Seek pre-approval within a short period: Pre-approval can trigger hard credit inquiries that damage your credit score. Depending on the model used, all auto loan inquiries made within 14 or 45 days will only count as one inquiry.
Make note of pre-approval offers: Once you have your pre-approval offers, make a note of the details so that you can compare them to secure the best deal for you. You should record the rates, expiration dates, maximum pre-approval amount and any applicable conditions.
Obtaining pre-approval can add certain negotiation power, including the following:
Better deals: Bringing a copy of your best pre-approval with you to the car dealership can help you bargain for a better deal.
Quicker purchase time: With loan pre-approval, you will avoid wasting time in the dealership financing office.
Seek pre-approval within a short period: Pre-approval can trigger hard credit inquiries that damage your credit score. Depending on the model used, all auto loan inquiries made within 14 or 45 days will only count as one inquiry.
More financial certainty: Loan pre-approval means you know what fits in your budget and how much it will cost.
Common Mistakes to Avoid
When determining car financing options, it can be easy to overlook important factors. In addition to checking your credit score and obtaining pre-approval, here are a few of our car loan tips to help you secure the best auto loan rates:
Not reading the fine print: Make sure you read your contracts carefully as there may be hidden fees and conditions which may affect the total cost of the loan.
Not determining other car-related costs: In addition to the loan itself, it is important to factor in other motor-associated costs. These include fuel, insurance, maintenance, registration and taxes.
Not making a note of pre-approval expiries: Pre-approval offers usually last between 30 and 60 days. If you find a car beyond this period you will need to re-apply for pre-approval and the rates may have changed.
Choosing a loan with long-term to lower payments: While this may seem favorable as it will reduce your monthly payments, you are likely to pay more in interest over time. This puts you at risk of owing more than the car is worth.
In sum, auto loans can be extremely beneficial when purchasing a car. They spread the cost of the vehicle over time, breaking it down into more manageable monthly payments. That said, it is important to do your research. Loan terms and conditions vary widely, and can be affected by your credit score and the size of your down payment. The auto loan process can be daunting but with the right tools, it can enable you to bargain harder when buying your next car.
