With the average price of a new car at a whopping $48,000 in 2023, according to Keller Blue Book, you’ll likely need to take out an auto loan to buy a car. But, before purchasing a vehicle, it’s best to research auto financing. Taking out a loan is a major decision, so it’s crucial to understand the common types of car loans, lenders, and key terms to know.
- Key terms you should know before taking out an auto loan include the interest rate, annual percentage rate, down payment, loan term, principal, monthly payment, and co-signer.
- You can get a car loan from dealer financing or a direct lender.
- There are a few factors to consider before applying for a car loan.
What is an Auto Loan?
An auto loan is an installment loan that allows you to borrow money from a lender to purchase a car. It is a legally binding contract between you and the lender where you will pay back the funds over a set period with interest and fees.
Key Terms to Know
Before going into the details about car loans, you should familiarize yourself with these common terms:
The interest rate on a loan is what the lender charges in return for providing funds to buy the vehicle. It is expressed as a percentage and shows how much you can expect to pay in interest for borrowing money. Typically, people with higher credit scores or shorter repayment terms get lower rates.
Annual Percentage Rate (APR)
The annual percentage rate (APR) is the total cost of borrowing. It includes the interest rate and any fees you will pay on the loan. The higher the APR, the more you will need to pay in return for the loan.
Similar to taking out a mortgage, many auto loan lenders require a down payment of at least 10 to 20% to finance a car. This is how much you will pay toward the car upfront. The higher the down payment, the lower your monthly payments will be. You can either pay this in cash or use the value of a vehicle trade-in. While some lenders do not require a down payment, the more you can put down upfront, the less you will need to borrow, and the lower the interest costs.
The loan term, or repayment term, is the length of time you have to repay your loan. Terms for auto loans typically range from 24 to 84 months. The longer your loan term, the lower your monthly payments, but the more interest you’ll owe. It’s best to choose a shorter repayment term with a monthly payment you can reasonably afford.
The principal is the amount you are borrowing to purchase the car minus interest, fees, penalties, and other costs. The principal and down payment equals the car’s total cost.
The monthly payment is how much you owe each month. It includes the principal, interest, and other fees. Part of your monthly payment goes toward the principal, while the rest gets applied to interest.
If you’re having trouble getting approved for an auto loan, applying with a co-signer could increase your approval odds. A co-signer is someone with good credit willing to share responsibility with you for your auto loan. This could be a parent or guardian, another relative, or a close friend. Having a co-signer could also help you secure a lower interest than you’d get on your own.
How Auto Loans Work
A car loan can make purchasing a vehicle more affordable because it breaks up the cost into monthly payments over a set period. Instead of paying the entire cost upfront, the payments get split across several years. Auto loans can range anywhere from a few thousand dollars to $100,000 or more. How much you can borrow will depend on the car you want to buy and your financial circumstances.
While you are paying off your car loan, the lender will likely hold onto your car title and be a lienholder on your car. If you miss a payment or make a late payment, the lender can repossess your vehicle. Once you successfully pay off the loan, the lender gets removed as a lienholder and will release the title to you.
There are different types of auto loans, including dealer financing, direct loans, and loans from online lenders. Factors like your credit score, loan amount, and vehicle type will play a role in the type of loan you should apply for.
Your monthly payment depends on the loan amount, terms, and interest rates. Let’s compare a $30,000 loan with different loan terms:
Using Calculator.net, if you take out a $30,000 loan for a car with a 60-month term and 5% interest, the monthly loan payments would be $566.14 per month. You would accrue $3,968.22 in interest.
If you shorten the term to 48 months, the monthly loan payments would be higher at $690.88 per month. But you would only accrue $3,162.18 in interest — a 20% difference!
Where to Get a Car Loan
Dealer financing is a type of financing dealerships offer directly to borrowers, allowing you to do your shopping and financing in one place. Typically, the dealer will check your credit to determine the rate and terms to offer you. If you have good credit, you may qualify for a promotional rate, such as 0% APR specials, rebates, or cash bonuses. When my sister purchased her car a few years ago, she qualified for 0% APR financing.
Dealers usually have relationships with multiple lenders, allowing you to compare terms. However, if you don’t have the best credit, you may have to pay a higher interest rate for in-house financing if you don’t qualify for a better rate elsewhere.
Direct lenders, such as banks, credit unions, and online lenders, work directly with borrowers. Because these lenders are competing for your business, you can shop around to find the best loan terms. Some may even give you the option to get preapproved for a specific loan if you agree to a soft credit check. Additionally, if you already have an account with a bank or credit union, you may qualify for a discounted interest rate if you take out an auto loan with them.
If you get approved by a direct lender, it may take at least one business day to get a loan and sometimes up to a week. Keep in mind that lenders may also have a minimum and maximum loan amount.
Requirements For Applying For a Car Loan
To get approved for an auto loan, you will typically need:
Lenders will pull a hard inquiry on your credit to determine your creditworthiness. Most require good to excellent credit to get approved for a loan. Some lenders may provide loans for borrowers with bad credit but usually charge higher interest rates. Before applying for an auto loan, check your credit on a site like AnnualCreditReport.com, which allows you to review your credit reports for free. If you find any errors, dispute them immediately with the appropriate credit bureau.
Lenders want to know that you have the means to repay your loan. During the application process, you will generally need to provide financial documents, such as pay stubs or a copy of your tax return. You may also need to provide current and past employment information.
Low Debt-to-Income Ratio
Your debt-to-income (DTI) ratio is the amount of debt you have compared to your income. The higher your debt obligations, the less likely you are to repay your debt. Lenders typically prefer borrowers with a DTI ratio of no higher than 50%, though some may require lower ratios.
Comparing Auto Loans
Here are some key factors to consider when comparing auto loans:
Annual Percentage Rate
If you have bad credit or opt for a longer-term loan, you’ll likely have to pay a higher APR, increasing the interest you owe over the loan’s lifetime. Alternatively, if you choose a shorter loan term or have a higher credit score, you may qualify for better rates. For example, if one lender offers you 7% APR and the other offers you 8%, taking the 7% will lead to less interest charges over time.
If you want to save money, you should pick a shorter loan term with a monthly payment that is within your budget. If you are cash-strapped, you may want to choose a longer loan term to lower your monthly payment.
Pay close attention to the origination and documentation fees. The origination fee is the cost you’ll pay to secure the loan, while the documentation fee covers the lender’s expenses for securing your loan.
In some instances, the loan amount you qualify for can be significantly less than the value of the car you want to purchase. In that case, you may need to provide a higher down payment to buy the car. For example, if the car you want is $40,000, but your loan amount is only $20,000, you will need to trade in a vehicle worth $20,000 or make a down payment of $20,000.
The Bottom Line
Before applying for an auto loan, check your credit scores and monthly budget to see how much you can realistically afford to pay for your car. If you don’t have the best credit, you may want to consider a co-signer or look for a lender who works with low-credit borrowers.