What is an auto loan?

An auto loan is a type of financing used to help you buy a vehicle, like a car or truck. Instead of paying the full cost of the vehicle upfront, you borrow money from a lender and repay it over time in fixed monthly installments.

Auto loans, also known as car loans, are secured with the vehicle you purchase, acting as collateral. The lender holds the car title until the loan is repaid; if you default, they have the right to repossess the vehicle.

Auto loans can be used for both new and used vehicles. The amount you can borrow depends on the price of the car, any down payment you make and your creditworthiness.

How do auto loans work?

An auto loan works by spreading the cost of a vehicle over a set period of time. 

Once approved, the lender typically pays the dealership directly for the full amount of the vehicle. You then repay the loan in fixed monthly payments that include the amount borrowed and the interest charged.

When assessing your auto loan application, lenders consider several factors, including your income, employment, debt-to-income ratio, and credit report.

Loan terms typically range from two to seven years, and the length of the term affects both your monthly payment and the total interest you will pay.

How much do auto loans cost?

An auto loan includes more than just the price of the vehicle. Understanding the full cost helps you set a realistic budget and avoid unexpected expenses after purchasing the car. The main costs included in an auto loan:

• Principal: This is the amount you borrow after any down payment or trade-in.
• APR and interest: This is the main cost of borrowing money, added to each monthly payment.
  Fees: Some lenders or dealerships may charge origination or processing fees.
• Sales tax: This is often added to the overall purchase amount and included in the loan amount.
• Registration and title costs: These may be required to register the car in your name.

The loan term also has a significant impact on the overall cost of your loan. Shorter terms have higher monthly payments but lower total interest, whereas longer terms reduce the monthly payment but increase the overall cost.

How a down payment affects costs

A down payment is an amount you pay upfront towards the cost of the vehicle. 

For example, if the car costs $12,000, you could pay a down payment of $2,000 and only need to borrow $10,000 with an auto loan.

As it reduces the total amount you need to borrow, it can make the loan more affordable. Even a small down payment can make a noticeable difference, especially if you have limited credit or a lower credit score.

A down payment may also increase your chances of approval. Since the loan amount is smaller, lenders face less risk, and your debt-to-income ratio may also improve.

How does depreciation affect an auto loan?

Depreciation refers to the gradual decrease in a vehicle’s value over time. Most cars lose value quickly, especially in the first few years. 

This is important when you have an auto loan, because the value of the car and the amount you owe do not decrease at the same rate.

When a car depreciates faster than your loan balance, you may end up owing more than the vehicle is worth, which is called being in negative equity. This can limit your options if you want to refinance, trade in or sell the car.

You could reduce the potential impact of depreciation by:

• Making a down payment to reduce the loan amount
• Choosing a shorter loan term if your budget allows
• Researching vehicles with slower depreciation rates

Understanding the impact of depreciation can help you select a loan term and repayment plan that aligns with your financial goals.

Types of auto loans

There are several types of auto loans available, and understanding how each works can help you choose the right option for your needs.

• Secured auto loans: This is the most common type of car financing, where the vehicle itself acts as collateral. Because the lender has security, they can come with lower interest rates than unsecured options.
• Unsecured auto loans: This is where you effectively use a personal loan to purchase a new vehicle. It means your car isn’t at risk if you fall behind on repayments, but they can be more expensive than secured auto loans.
• Simple interest auto loans: Most auto loans are simple interest loans. The interest is calculated daily based on the outstanding balance. Paying early or making additional payments can reduce the overall interest you pay.
• Precomputed interest auto loans: The total interest plus fees is calculated upfront and divided over the loan term. This means you can’t reduce the interest by overpaying because it has been assigned to each payment.
• Lease buyout loans: This type of car finance helps you buy a vehicle you’ve been leasing. If you have the option to buy the car at the end of the lease, you can use a lease buyout to finance this purchase. 
• Buy-here, pay-here (BHPH) loans: BHPH financing is offered directly by some car dealerships, typically for buyers with limited or poor credit. They usually come with higher interest rates, making them an expensive option.

What credit score do you need to get an auto loan?

There is no specific credit score required to get an auto loan. Lenders consider several factors when reviewing an application, and it may be  possible to get a car loan with bad credit. 

However, according to data from Experian, borrowers with a prime or super-prime VantageScore (above 660) can qualify for significantly lower interest rates than those with a subprime or deep subprime score (below 600). 

Your credit score is only one part of the decision, and lenders will also typically look at:

• Your income and employment stability
• Your debt-to-income ratio
• The size of your down payment
• The age, price and condition of the vehicle

If you have poor credit, you can still finance a car by choosing a loan that fits your budget and by demonstrating your ability to meet the monthly payments.

What are the alternatives to using an auto loan?

Using an auto loan to purchase a car is a popular option, but there are alternatives that might be a better fit for you.

Leasing allows you to use a vehicle for a specified period with fixed monthly payments. You do not own the car unless you choose a buyout at the end of the term. 

Paying for a new or used car in cash avoids interest and monthly payments, but you will need to have enough savings to cover the cost upfront. 

You could also consider financing through a credit union if you’re a member, which may offer flexible terms if you have a limited credit history. 

How to get an auto loan

Here are the main steps to follow if you have decided an auto loan is the right option for you:

• Review your budget: Work out how much you can afford to spend each month on a car payment and other vehicle costs.
• Check your credit: Look at your credit score to help you understand the interest rate and terms you may be offered.
• Save for a down payment: Putting money down reduces the amount you need to borrow and may improve your chances of approval.
• Compare loan options: Look at interest rates, loan terms and monthly payment amounts to find the option that suits your financial situation.
• Submit your application: You can apply online, at a dealership or through a financial institution.

Preparing ahead of time can make the process easier and help you choose a loan that works for your needs.

How to refinance an auto loan

Refinancing your auto loan means replacing your current loan with a new one, usually with better terms. To refinance an auto loan, you should:

• Review your current loan and check the terms and remaining balance
• Check your credit score, as you may qualify for better terms if it has improved
• Compare refinancing deals to find a better deal than your current loan
• Check prepayment penalties and origination fees to make sure refinancing is worth it
• Apply for a new auto loan that offers improved terms

Refinancing can be a helpful option if you want a lower monthly payment, a reduced interest rate or a shorter loan term. 

Ensure that the savings outweigh any fees and that the vehicle still retains enough value for you to qualify.

Is an auto loan the right choice for you?

An auto loan can be a good option if you want to spread the cost of a vehicle over time with predictable monthly payments. It may also help you access a wider range of cars than you could afford up front. 

However, the right choice depends on your budget, credit history and financial goals. Before borrowing, consider the total cost of the loan, whether the payments fit within your income and how the vehicle’s value will change over time. 

Taking the time to compare your options can help you choose the car finance option that best supports your needs.