What Is an Auto Loan?

If you've set your sights on a particular car, but the price tag is beyond your immediate reach, consider getting an auto loan. This is a type of financing provided by various lenders to help you purchase a vehicle that you otherwise couldn't afford outright.

According to the Federal Reserve Bank of New York, Americans owed $1.56 trillion in auto loan debt during the first quarter of 2023. This accounts for 9.2% of American consumer debt, making auto loans the third-largest debt category behind mortgages and student loans.

By understanding auto loans and how they work, you can secure a deal that fits your budget and financial goals, while avoiding unnecessary costs, negotiating better terms and ultimately driving off the lot with not just a new car but also peace of mind.

An auto loan allows you to borrow money from a lender to purchase a vehicle. It's a type of installment loan, meaning you have to repay the loan amount and interest in regular monthly payments over a predetermined period. This period, often referred to as the loan term, can range from a few years to as long as seven years or more.
Because your loan is secured by the vehicle itself, your lender has the right to repossess the car if you default on your payments. The amount you can borrow and the interest rate you receive are typically determined by several factors, including your credit score, income, the price of the vehicle and the size of your down payment.

Before applying for an auto loan, it's important to familiarize yourself with these key terms:

• Amortization: This is the process of paying off your loan over time through regular payments. Each payment goes towards both the principal and the interest.

• Annual percentage rate (APR): This is the yearly cost of the loan, including interest and all fees. It gives you a comprehensive view of the loan's cost.

• Down payment: This is the upfront amount you pay when buying a car. It reduces the total amount you need to borrow.

• Loan term: This is the length of time you have to pay back the loan. It's usually expressed in months, such as 36, 48 or 60 months.

• Loan-to-value ratio (LTV): This is the ratio of the loan amount to the value of the vehicle. A lower LTV often means lower risk for the lender.

• Principal: This is the initial amount of money borrowed to buy the car. It doesn't include any interest or additional fees.

• Prepayment penalty: This is a fee some lenders charge if you pay off your loan early. It's important to check for this before signing a loan agreement.

• Total cost: This is the full amount you have to pay over the life of the loan. It includes the principal, interest and any down payment or trade-in.

Navigating auto loans involves understanding the different types available, including direct auto loans, indirect auto loans, precomputed auto loans and simple interest auto loans.

Direct auto loans are a type of financing that you obtain directly from a financial institution, such as a bank or credit union. They often offer competitive interest rates, especially if you have a good credit score. Plus, you can shop around and compare offers from different lenders to ensure you're getting the best deal.

However, direct auto loans may require a higher credit score for approval compared to other types of auto loans. This means that if your credit score isn't in good shape, you might find it more challenging to get approved for a direct auto loan.

Once you've secured a direct auto loan, you can use it to purchase a vehicle from a dealership or a private seller. This gives you the flexibility to shop around for the perfect vehicle without being tied to a specific dealership.

An indirect auto loan is a form of financing where the car dealership facilitates the loan for you. In this scenario, the dealership acts as a middleman between you and the actual lender, which could be a bank, credit union or other financial institution.

When you choose an indirect auto loan, you essentially complete your financing and vehicle purchase in one place, which many people find convenient. This allows you to streamline the car buying process by handling both the vehicle selection and financing in one location. Plus, dealerships often have relationships with a variety of lenders, which can increase your chances of getting approved for a loan, especially if your credit isn't perfect.

It’s worth noting, however, that dealerships might mark up the interest rate to compensate for their role in facilitating the loan. This means that indirect auto loans can sometimes come with higher interest rates or additional fees compared to direct auto loans.

A precomputed auto loan is a type of loan where the total amount you'll pay over the life of the loan is calculated in advance. This total amount is then divided by the number of months in your loan term to determine your monthly payment.

With a precomputed loan, your monthly payment is fixed, and each payment is split between interest and principal according to a pre-established schedule. This means you know exactly how much you'll pay each month and how much you'll have paid by the end of your loan term, making budgeting easier.

However, there’s less flexibility if you want to pay off your loan early. Since the interest for the entire loan term is calculated and included in the total loan amount upfront, you may end up paying more interest than you would with a simple interest loan if you decide to pay off your loan early.

With a simple interest auto loan, the interest is calculated on the outstanding balance of the loan. This means that as you make payments and reduce the principal amount of your loan, the amount of interest you pay also decreases.

In a simple interest auto loan, your monthly payment is divided into two parts: a portion that goes toward paying off the principal and a portion that goes toward paying the interest. Early in the loan term, a larger portion of your payment goes toward interest. As you continue to make payments and the principal decreases, more of your payment goes toward paying down the principal and less toward interest.

Simple interest auto loans can help you save on interest by allowing you to make extra payments or pay off your loan early. However, if you miss a payment or pay late, more of your next payment will go toward interest and less toward the principal, which could extend the time it takes to pay off your loan.

Before getting an auto loan, it's crucial to consider several key factors that can significantly impact your financial commitment and the affordability of your loan.

• Credit score: A higher credit score often leads to better loan terms, including lower interest rates. For example, if you have a credit score of 720 or above, you're likely to qualify for the best interest rates. If your credit score is lower, it might be worth taking some time to improve it before applying for an auto loan.

• Budget: Consider how an auto loan fits into your overall budget. Can you comfortably afford the monthly payments along with your other expenses? If a $400 monthly payment means you'll be stretched too thin, it might be worth considering a less expensive car or saving for a larger down payment.

• Interest rate: The interest rate on your auto loan directly impacts the total cost of the loan and your monthly payments. It's crucial to shop around and compare interest rates from different lenders. For instance, getting a loan with a 3% interest rate instead of 6% can save you a significant amount of money over the life of the loan.

• Loan term: While a longer term can lower your monthly payments, it also means you'll pay more in interest over the life of the loan. If you extend a loan term from 48 months to 72 months, it can make your monthly payments more manageable, but you'll end up paying more in total interest.

• Down payment: A larger down payment often reduces the amount you need to borrow, leading to lower monthly payments and less paid in interest. If you can afford to put down 20% of the car's price, for example, you'll have a smaller loan and own a larger share of your car right from the start.

• Total cost of the loan: It's important to consider the total cost of the loan, including the principal, interest and any fees, to get a clear picture of your overall financial commitment. For instance, a loan with a lower monthly payment but a longer term may end up costing more overall than a loan with a higher monthly payment but a shorter term.

• New car vs. used car: Interest rates can vary depending on whether you're buying a used car or a new one. Used cars can sometimes have higher interest rates due to the increased risk to the lender. However, they often have a lower purchase price, which can offset the higher rate.

Getting an auto loan involves a series of steps that require careful planning and consideration. We broke down the important steps you should take to navigate this process better.

Auto loan pre-approval and prequalification are two processes that can help you understand how much you might be able to borrow before you go car shopping. While they may seem similar, they serve different purposes and involve different levels of commitment from lenders.

Prequalification gives you an estimate of the loan amount, terms and rates you might qualify for based on your creditworthiness and financial situation. Note that it’s not a guarantee of approval or specific loan terms. It's simply an estimate that can help you start planning your car purchase.

On the other hand, a pre-approval is a conditional commitment from the lender to lend you up to a certain amount under specified terms. During pre-approval, the lender will verify your financial information and offer specific loan terms, including the loan amount, interest rate and loan term.

Securing an auto loan is a key step in the car-buying process, and knowing where to look for one can make the process smoother and more efficient. From traditional banks and credit unions to online lenders and dealership financing, there are several options available to prospective car buyers.

Banks: Banks are traditional lenders that offer a variety of loan products, including auto loans. They often have more resources and can offer competitive interest rates. When you get an auto loan from a bank, you can often manage your loan through the same online banking system you use for your other bank accounts, which can be convenient.

Credit unions: Credit unions are member-owned financial institutions that often offer lower interest rates than banks. To get an auto loan from a credit union, you typically need to be a member, which might require living, working or studying in a certain area or working for a certain employer.

Online lenders: Online lenders can offer convenience and fast approval times. They allow you to apply for an auto loan from the comfort of your home and often make a decision quickly. However, it's important to do your research and choose a reputable online lender.

Dealership financing: Dealerships often offer financing through their own network of lenders. This can be convenient because you can choose your car and secure your financing in one place. However, dealership financing might not always offer the best interest rates, so it's important to compare their offer with other options.

Peer-to-peer lenders: Peer-to-peer lending platforms connect borrowers with individual investors who fund their loans. These platforms can offer competitive interest rates and a fast online application process. However, they might have stricter credit requirements than other lenders.

Auto loans can be complex, and it's natural to have questions as you navigate the process. We answered some frequently asked questions to help guide you on your car-buying journey.