It can be confusing and troublesome trying to find the best possible auto loan for an automobile. But how do you know what constitutes a “good deal?” Well, you have many options to consider before figuring out whether or not you are making out a bargain. First, you need to understand the factors that affect your borrowing power and know the various available financing options. With the right guidance, you can make out with the best auto loan for your needs and an equally affordable repayment plan that won’t the bank.
Factors that affect your auto loan
Let’s begin by going over some key auto loan terms and concepts that you need to know as you look for financing. There are three main factors that can affect the structure of your auto loan, as well as how much the loan will cost overall:
Loan amount
Also known as the principal, this is the amount of money you borrow with the loan and agree to pay back. The upside is that you can reduce your auto loan principal by increasing your down payment or by offering a trade-in.
Annual percentage rate (APR)
This is your interest rate that is added on top of your principal loan amount and any lender fees. APR is generally based on your credit history and your credit score. The better your credit score, the lower your annual percentage rate. The APR you get on your loan will affect both your monthly payment and the total cost of your loan.
Loan term
The term of a loan is the length of time you are afforded to pay off your loan. Loan terms come in twelve-month increments – 24, 36, 48, 60, 72, and 84 months. When choosing a term, be aware that a shorter term will increase the monthly payments but decrease the total cost of the loan. Conversely, a longer term will decrease the monthly payments and increase the total cost of the loan.
Generally, it is recommended to take out a loan that you can pay off in no longer than 60 months for new cars and 36 for used cars.
Types of Auto Loans
Often people require loans to purchase cars, it is rare to see someone buy a car in cash. And there are several types of car loans available to you. So, where do you begin? Well, let’s start by going through the various types of auto loans at your disposal:
Secured auto loan
A secured loan requires the buyer to put up collateral to borrow money. Most auto loans are secured loans as the car being purchased is the collateral. Failing to repay the loan will result in the car being repossessed. Secured auto loans are easier for people with poor credit history to get, compared to an unsecured loan.
Unsecured auto loan
An unsecured auto loan is essentially a personal loan used to purchase a vehicle. If you don’t make your payments, that debt would be sold to a debt collection agency instead of the car being repossessed. These types of loans generally have higher interest rates because of the risk they pose to lenders. Why would anyone opt for an unsecured auto loan?
Some buyers choose this option because lenders have restrictions on which vehicles are eligible for a traditional (secured) auto loan based on vehicle age, mileage, or cost.
Simple interest auto loan
Another factor that may affect the repayment structure of your auto loan is whether it’s a simple interest or a precomputed interest loan.
Most auto loans tend to be simple interest loans; monthly payments that are calculated based on the interest rate and the total balance remaining. Interest is accrued daily and is added to the total balance. Interest charges are the greatest during the beginning of repayment, but decrease as more of the principal balance is paid off. This, however, can sometimes be tricky.
With simple interest loans, the monthly payment first goes towards paying the interest charges. The remainder of the payment (if any) will go towards paying down the principal loan amount.
If you were to only pay the minimum amount due each month, your auto loan balance wouldn’t decrease. Instead, it would grow larger and larger, making it harder to pay down the principal balance — similar to the trap of only making minimum payments on credit card debt.
There are ways to get around this and minimize interest charges. Simple interest loans allow for making additional payments on top of regular monthly payments without penalty. Putting more money towards the loan early on can mean that more money goes towards the principal balance, thereby reducing the amount of interest that’s charged over the duration of the loan.
Precomputed interest auto loan
With a precomputed interest loan, interest (along with origination fees and the loan balance) is totaled and divided into equal payments across the loan term. Using what’s known as the Rule of 78, lenders calculate all the interest you would pay over the life of the loan and include that in your monthly payments. Interest charges are fixed and do not change even if additional payments are made.
This means borrowers have the peace of mind to make fixed monthly payments where a consistent amount will go towards the principal balance and interest charges, regardless of how much of the principal balance they still owe. The drawback, however, is that there’s no benefit to paying off the auto early.
Although federal law requires lenders to refund borrowers who pay off their loans early, the nature of precomputed interest works in favor of the lenders through a tricky calculation loophole that entails borrowers being entailed the smallest amount possible.
For these reasons, precomputed interest loans aren’t usually recommended (some states have even gone so far as to outlaw them!). The only time you should consider taking on a precomputed interest loan is when you are certain you will be incapable of increasing your payments to reduce interest rates.
Subprime auto loan
These are secured auto loans made for borrowers with poor or fair credit scores. The downside is that your interest rates will be much higher. And because lenders see subprime loans as risky you may be asked to provide W-2s, pay stubs and/or bank statements to verify your income.
If possible, you want to fix your credit prior to applying for an auto loan, so you can get an auto loan for prime credit. It will have a much better rate and may offer better terms.
Lease buyout loan
A lease buyout is the process of purchasing a car that you are already leasing. If you are happy with or cannot be bothered with dealing with the hassle of finding a new car, you would go ahead and apply for a lease buyout loan to purchase the car from the dealership or manufacturer.
Military auto loans
For active Service Members, as a sign of appreciation, dealerships and auto lenders tend to offer special discounts or incentives that sometimes extend to Veterans as well.
Title loan
A title loan, also known as pink slip loans or title pawns, is not a loan to purchase a car, but it is a loan related to your vehicle. It allows you to quickly borrow a small amount of cash at a high interest rate by giving the title of your car over to a lender and paying a monthly fee.
You will have to repay the loan plus interest in 15-30 days. Should you fail to do so, the lender can keep your car. These types of loans are not recommended, as you can lose your means of transportation if you fail to repay the loan.
How car loans work
Now that you have an idea of the types of loans available to you, let’s go over how car loans work exactly. Your monthly payments depend on the amount of your loan, the loan term, and the interest rate of the loan.
Your loan contract is broken down to include the principal loan amount and the annual percentage interest rate on the loan. Although longer term loans may lower your monthly payments, you end up paying more in interest over the long run. And this may cause you to be “upside down” on your loan, which is another way of saying you owe more than the actual worth of the car.
So, let’s take a look at an example where we compare a $30,000 loan at 3.5% APR across two different loan terms (48 months and 72 months). Bear in mind that we have not included any taxes on this breakdown:
| Loan term for a $30,000 car | Monthly payment | Total interest paid – 3.5% |
|---|---|---|
| 4 years (48 months) | $670.68 | $2,193 |
| 6 years (72 months) | $462.55 | $3,300 |
Notice how your monthly payments decrease with a longer loan term. But also notice how you would be paying $1,107 more in interest charges for the longer-term loan. Thus, it is always best to look at the overall cost of the vehicle as well as the monthly payments you will make. Just because you are making lower monthly payments does not necessarily mean you are making out with savings.
Another important thing to consider with your loan is who will be extending you the loan:
Direct lending
Direct lenders are usually banks or credit unions, as well as other online lending institutions. When you borrow from one of these lenders, you are given the opportunity to compare loan terms. You can even get pre-approved for your auto loan, which can give you the upper hand in negotiations when purchasing a vehicle.
Indirect lending
Dealership financing is an example of indirect lending. You get your auto loan through the dealership where you purchase your vehicle. This means that technically, you do not need to contact a lender prior to visiting a dealership when you want to buy a car.
Since dealerships generally have good relations with various lenders or on-site financing departments, they may be able to get you low rates. They may also offer incentives, such as zero percent down where you don’t need any money for a down payment, or no interest for a set time when you first open the loan.
Be aware that these incentivized dealership offers may seem like they save you a lot of money, but they can end up being more costly overall. That’s why you want to get preapproved with a direct lender first and then take that offer to the dealership. Make sure to compare the overall cost of the dealership offer with your preapproval.
Where to shop for auto loans
Before you pick out your next set of wheels, you’ll need to do some light homework on auto financing options from banks, dealers, credit unions, and online lenders. Some may be more likely than others to try and help your given situation, while others may take advantage and charge you higher interest rates because of lower credit scores.
Car dealerships
Dealers tend to work with banks and automaker financing groups to offer shoppers comparable loan rates. They are also convenient because they are a one-stop-shop for your vehicle needs and they can handle getting you a loan. And dealerships may be willing to help people with lower credit scores, however, know that you will likely be paying higher interest rates, especially if you have bad credit.
Additionally, manufacturer-sponsored loans are only available to customers with high credit scores.
Banks
Since banks are established lenders, they are often able to offer very competitive loan rates. But be aware that generally banks have conservative loan policies and may cater to consumers with higher credit standings. However, you can still find banks that are willing to offer loans to consumers with bad credit.
As you shop for loans, you may want to contact local independent banks, as well as get quotes from national banks. Local banks may offer better rates and more flexible lending terms.
Credit unions
Credit unions operate similarly to banks except they are nonprofits owned by depositors. Often, credit unions will only offer loans to members and are more willing to work with borrowers who have had some bumps down the road with their credit history. However, they do sometimes make exceptions for non-members who meet certain criteria. They also usually offer lower interest rates on loans and credit cards.
Online lenders and loan comparison tools
There are also lenders that you can find online which do nothing but provide loans to people. Online lenders tend to have much more flexibility in approving people with bad credit. Another advantage of shopping for your auto loan online is that you can use loan comparison tools to compare offers from multiple lenders at once.
Getting pre-approved for a car loan
Shopping around for loans or finding the best financing options available to you prior to your dealership visit can hugely impact your negotiations. Think of it this way: The wider you cast your net, the more likely you are to find the best deal. Moreover, by getting pre-approval for an auto loan, you will likely know firsthand the price range you can afford, the length of your loan, as well as the interest rate or APR for your loan.
However, keep in mind that when you apply for a new credit line, it affects your credit score for a limited time. The good news is that credit bureaus often treat a cluster of auto loan applications in a short period of time as a single application rather than multiple applications that could heavily impact your credit score. We recommend keeping all your auto loan applications confined to a 30-day period to avoid heavy negative impacts on your credit score.
Auto loan rates by credit score
Unsurprisingly, loan rates vary depending on your credit score. The higher your credit score the more likely you will make out with a low interest rate. And the lower your credit score, the higher interest rates because lenders see you as a higher-risk candidate.
| Credit Score | Average APR for New Vehicles | Average APR for Used Vehicle |
|---|---|---|
| 781-850 | 5.18% | 6.79% |
| 661-780 | 6.40% | 8.75% |
| 601-660 | 8.86% | 13.28% |
| 501-600 | 11.53% | 18.55% |
| 300-500 | 14.08% | 21.32% |
Based on the Experian State of the Automotive Finance insights from Q1 2023.
Before picking the first loan at your disposal, take a look at the various other options that may be available to you. The more options you have, the better your chances are of striking a good deal with a dealership or manufacturer. And suppose you have a low credit standing. In that case, it may be in your best interest to do research and get pre-approval for an auto loan rather than heading to a dealership and accepting their potentially higher interest rate loan.
