How do Car Loans Work?

Buying a car is a big purchase, but just like buying a home, it’s a worthwhile investment—one that requires understanding the process and shopping around to get the best price.

While cars are designed to take you from A to B, vehicles today are equipped with all kinds of high-tech and luxurious features to make the journey as comfortable and safe as possible. But what about the price tag?

Whatever your financial situation, a car loan may be the solution you need to afford the car of your dreams.

In this article, we’ll review how car loans work and what you need to know.

 

Types of Car Loans

Similar to other types of loans, auto loans come in two varieties: secured and unsecured. So what’s the difference and which should you choose?

Let’s take a look.

 

Secured Loan

A secured auto loan means the lender has a lien on the vehicle, which is essentially an insurance policy for the lender that allows them to reclaim the vehicle if the borrower fails to pay back the loan for any reason.

Only once the car is paid off in full will the lender sign over the title to the borrower and release the lien. In short, you’re using your car as collateral on the loan, which comes with some benefits.

The appeal in taking out a secured car loan is that they’re easier to qualify for and you’re more likely to secure a better interest rate.

 

Unsecured Loan

An unsecured loan simply means that there is no lien on the car’s title and the lender wouldn’t be able to repossess the vehicle if the borrower were to default on their loan. If this happened, the lender would have to pursue other avenues in reclaiming the auto payments, like sending the debt to collections.

This, of course, means more risk for lenders since they don’t have any collateral on the loan, which would result in higher interest rates and stricter qualification requirements for the loan.

 

How the Process Works

A car loan works fairly similarly to other kinds of loans. You find a lender to borrow money from (assuming you’re not going to be paying for the car in cash) and you pay that money back over a fixed period of time—plus interest and fees.

How to Find Lenders

Finding auto loan lenders has never been easier and goes beyond your brick and mortar banks. There’s a wealth of reputable online lenders that cater to borrowers from all kinds of financial backgrounds.

Some specialize in offering car loans to borrowers with low credit scores (which means higher interest rates) and others are best suited for those with good credit scores (meaning low interest rates).

LightStream is one online lender that offers a variety of loans online, including auto loans, for low rates, but you’ll need to have excellent credit to qualify.

Best Egg is an online lender that offers personal loans for cars with a fixed APR. You can visit their website and get a quick quote by submitting some basic information to see what you qualify for.

If you’re more interested in quickly comparing rates from multiple lenders, Lending Tree is a platform that allows you to search through their network of lenders to find a loan with the best rates based on your specific financial profile. Rather than wasting time submitting multiple applications, you can submit your information on their website and immediately get matched with lenders.

 

Application Process

A big benefit to using an online lender is that everything is conducted online. There’s no need to step foot in a bank. So where does the process begin?

To find the best auto loan rates, you’ll need to shop around. Once you find a few reputable lenders, you’ll want to get pre approved. Getting pre-approved just means that you’ll be able to see the interest rate and loan terms you qualify for. If they’re favorable, you can go ahead and complete the application process.

This process will vary somewhat, depending on the lender—for example, some will require a hard credit check and others won’t—but generally, they all require the same personal details, like your name, address, credit score, social security number, salary, and debts.

 

Credit Score and Debt-to-income-ratio

Your credit score is an important factor in the application process, as is your debt-to-income ratio. These factors, along with your salary, will determine what kind of interest rates you qualify for.

Those with high credit scores between 781-850 can get interest rates as low as 2-3%. For those with the lowest credit scores, between 300-500, you can expect interest rates to be at least 14% or higher.

This is why it’s a good idea to know what your credit score is before applying. You don’t want to go into the application process blind. Knowing your credit score will help you understand what kind of rates you can expect for your auto loan.

You can easily acquire a free credit score at any of the three major credit bureaus—Equifax, Experian, or TransUnion.

Your debt-to-income ratio is also important because it represents how much debt you have compared to how much you’re earning. This matters to lenders because it helps them determine how much they’re willing to let you borrow.

These factors will all play into the annual percentage rate, or APR, you qualify for. The APR should be a key consideration when shopping around for lenders, as this is essentially what it’ll cost for you to take out the loan—i.e. Interest and fees.

After all, nothing is free. So the higher the APR, the more you’ll be paying for the loan. With that said, a down payment (which could be cash or the value of a trade-in vehicle) will help lower the amount of your monthly payments.

 

Pre-approval Vs Pre-qualification

So we’ve mentioned both of these terms in the previous section, but are they the same?

There’s actually some key differences between pre-approval and pre-qualification when it comes to car loans.

Pre-approval typically means you can expect the lender to conduct a hard credit check to see your credit score and other financial profile details. Since the lender does a bit more digging into your personal background here, you can generally expect the offered rate to be accurate once you move forward with finalizing your application.

A pre-qualification, on the other hand, is when a lender only conducts a soft credit pull, meaning the information they have on you is much more limited. With a pre-qualification, you’ll may find that the estimated rate may change once a full credit check is conducted.

If you’re just looking to quickly compare lenders to see what rates look like, it’s a good idea to get a pre-qualification from multiple lenders since a soft credit check won’t hurt your credit score.

Once you submit your pre-approval or pre-qualification, you can expect to be contacted by the lender via phone calls and emails, so be prepared for a bombardment of communication requests.

 

Loan Terms

When you’re pre-approved for a loan, you’ll see not only the estimated APR but the loan term. This is how many years you’ll be paying the loan off, which will affect the monthly payment. Shorter loan terms result in higher monthly payments and longer loan terms result in lower monthly payments.

While it’s tempting to choose to pay off your loan over the longest period of time possible, remember that you’ll be required to pay interest over the life of the loan, which can add up.

 

Conclusion

The benefits that come with owning a car, whether it’s new or used, are innumerable. Not only is a vehicle an investment, but it can often feel like an extension of ourselves.

Taking out a car loan is a process, but working to strengthen your financial profile in addition to conducting thorough research of reputable lenders will ensure you find the best rates available.

Jessica Cotzin Jessica Cotzin Last update:
Jessica Cotzin is a writer and the Lendstart authority on small businesses and personal loans. She has been writing about personal finance and the loans industry for a number of years, and holds a bachelor’s degree in journalism from Florida Atlantic University.